The fourth quarter of 2018 was uncomfortable. After an unprecedented period of calm on the financial markets in 2017, increased global uncertainty and growing cyclical concerns caused increased volatility in the markets.

Translating into one of the worst quarters of the last decade, few asset classes remained unscathed as the New Year was ushered in.

Discussions at our Investment Committee reflect this shifting landscape. As ten years of robust economic growth shows signs of strain, the global backdrop begins to crack under the pressure.

Growth in the Eurozone and Emerging Markets has disappointed and even the US, which seemed immune to global pressures for the majority of 2018, flashed warning signals from the manufacturing and transport sectors by the end of the year, although employment levels remained strong.

Investors will have to navigate both an uncertain backdrop and cyclical pressure in 2019, but there will be opportunities for growth. If Central Banks manage their monetary policy programmes well, trade tensions ease and Brexit negotiations lead to a solution that’s welcomed by markets, financial markets could rebound.

Why now?

Most will recognise that tensions on the global stage didn’t emerge over night. Yet financial markets chose to ignore this unpredictable backdrop for a number of consecutive quarters, favouring unusually low levels of volatility instead.

A complex picture has now emerged. Growth concerns were exacerbated by the medley of political tension, triggering an accelerated repricing of equities in the fourth quarter, shifting valuations south.

Equities had previously traded at historically lofty valuations, supported by strong earnings growth. However, this earnings momentum has shown signs of reaching its peak, just as equity valuations have slumped.

The Brexit countdown is entering its final weeks, and after close to two years of negotiating, the potential outcomes are still too broad to say with any certainty.

In the Eurozone, Italy has faced budgetary headwinds from the European Central Bank (ECB) and violent protests erupted in France against the cost of living, calling for President Macron’s resignation.

Across the pond, the midterm elections handed control of the House of Representatives back to the Democrats for the first time in eight years, with the paralysis of the US budget indicating that the next year is likely to be a difficult one for President Donald Trump.

Trade issues escalated over the course of the year, the impact of which are already being felt on both sides of the commercial spat – headlines around the impact on US farmers were popular in the quarter.

The costs of shipping from China to the United States rose and American giant Apple, a symbol of the decade-long bull market, revised its Chinese sales forecasts, with painful consequences on the stock market.

Then there was the arrest of a senior executive of Chinese technology champion Huawei at the request of the American authorities, all whilst Trump ate dinner with Xi Jinping at the G20 summit.

Trade negotiations are ongoing and whilst there may be some progress on trade, other issues like Intellectual Property protections may be tougher to resolve.

Brexit

Uncertainty in the US managed to knock Brexit off the front pages for a couple of weeks, but it’s still going to be a major event for the first quarter of 2019.

With less than 100 days on the calendar until the UK is set to leave the European Union, the outlook is no less uncertain. The story changes by the hour: whether it’s the date of the Parliament vote, Theresa May’s attempted No Confidence coup, the details of her deal, or the opposition’s response to it. The uncertainty is very difficult for financial markets to price in.

The consensus is that a No Deal will be bad for markets and the economy, and there is a large bias against a No Deal. We see this reflected in sterling, which depreciates when the risk of No Deal increases.

If we do see the deal passed, we’d expect financial markets to take that quite positively, as it removes some of the uncertainty that we’ve had to live with over the past few months.

Since the referendum result was announced, we have been adjusting portfolios to limit the downside and capture as much upside as possible in the final Brexit outcome.

We’ve maintained our low exposure to UK-focussed risky assets and have taken steps to remove our vulnerability to currency volatility. If you have any questions about how your portfolio is prepared for Brexit, get in touch with your Investment Consultant, who will be happy to talk it through.

US Monetary Policy

Rarely is one quarter so heavily directed by one theme, yet America’s Central Bank, the Federal Reserve, had financial markets hanging off its every word in the final three months of 2018.

During periods of uncertainty and tension, investors look to Central Banks to support the economy with loose monetary policy to promote expansion – although it’s not in the Fed’s job specification to manage market volatility.

Yet global policy makers want to return to normal monetary policy after an unprecedented programme of policies designed to promote economic expansion following the financial crisis.

The Fed hiked interest rates in December’s final meeting of 2018, and although the move was expected, the unanimous vote spoke to investors’ nervous disposition.

The markets had prepared for four interest rate hikes in 2019, yet a shift in the political and economic backdrop translated into a softer outlook for monetary policy.

In response to market volatility, Federal Reserve Chair Jay Powell reassured investors that the Central Bank wasn’t prepared to complete its interest rate programme at all costs, and would listen to the wider economic scenario before making any concrete decisions. Fed members now expect two rate hikes in 2019, down from three in October.

The market isn’t as convinced, however, with the probability of no rate hikes in 2019 jumping from below 20% in October to close to 80% probability at the time of writing.

The question is whether the Fed will fall in line with the market. For equity markets to recover, the Fed will probably need to signal that it will pause its monetary policy programme.

Fourth-quarter performance

Suffering from one of the worst quarters for ten years, it’s difficult to find many winners in this environment.

Developed market equity slipped 13.3% in the fourth quarter, accelerated by a 7.6% decline in December alone. The fourth quarter performance unwound the market’s recovery from volatility earlier in the year, with the sector ending the year down 8.2% in dollars.

Compared to the sharp falls experienced in early 2018, Emerging markets held up a little better, although still ended the quarter down 7.6%.

Although interest rates still remain at historically low levels, government bonds were stable, confirming their attractiveness as a diversification tool amid uncertainty. The main bond indices of Europe, the United States and Japan closed the year on a positive note, beating all expectations.

Investment Grade Bonds benefited most from the fall in interest rates, closing the quarter almost unchanged.

It was a different story for corporate debt, however, which suffered from the risk-off environment.

Economic weakness did cause demand for oil to fall, removing the support for its price. The commodity index as a whole lost 10.5% in dollars over the quarter.

Chart 1

Is this level of volatility normal?

Global equities slumped in the fourth quarter, but is this behaviour investors should expect from the stock market?

After two years of calm, it might seem rare and will probably feel uncomfortable, but, in reality, markets have fluctuated like this before, and will do so again in the future.

Take a look at the distribution of historical returns from the S&P 500 in Chart 2, on a monthly, quarterly, and annual basis.

The black line shows the distribution of monthly historical returns, highlighting performance from October, November and December.

If you can imagine the 91 year lifespan of the S&P 500 fits into 100 months, December’s performance falls into one of the three worst performances, with October’s performance falling into the bottom six. This won’t be too much comfort, but it should reassure investors that these market movements are not unparallelled.

Chart 2

The quarterly performance is also interesting. The S&P 500 slipped 14% in the fourth quarter, but as this is in the bottom 7% of quarterly performances, however, investors should expect three or four quarters of similar returns across a ten-year time horizon.

Chart 3 and Chart 4 put the fourth quarter and 2018 performance of the S&P 500 into simple context. Fourth quarter performance was difficult, yes, but investors have sat through similar scenarios before.

Chart 3

Chart 4

Volatility on the S&P 500 is measured by the VIX, and is often used as a benchmark for global equity markets. The VIX sat at historically low levels for the entirety of 2017 and early 2018.

Looking at Chart 5, you can see that such low levels of volatility is unusual. Whilst the return of price fluctuations will have been a rude awakening for many, this environment has been seen before. In fact, 45% of quarterly volatility levels have been higher since 1990 than what was seen in the fourth quarter of 2018.

Give yourself the elusive edge

During uncertainty, many promote timing the market to avoid volatility, yet this tactic comes with its own financial health warnings.

Instead, it’s ‘time in’ the market that can provide you with the elusive edge as an investor to maximise your returns.

You can see from Chart 6 that the probability of loss when investing in Developed Equities given your time horizon falls dramatically depending on how long you are invested.

The longer you’re invested, the less likely you are to see losses in your portfolio.

If you’d like to discuss the performance of the model portfolios or want to know the thinking behind the Moneyfarm investment strategy, please call your Investment Consultant on 0800 4334574, or book a call.

You could argue that the past three months in financial markets has been directed by just one subject; the US Central Bank.

In early October, the Federal Reserve’s (Fed) Chairman Jay Powell remarked that the Fed was a long way from neutral rates – where economic growth and inflation is stable. After the expected rate hike in December, Powell said the Fed was still upbeat on US growth, even if market participants were taking their nerves out on the financial markets.

The market vs the Fed

The Fed regularly publishes anonymously where its members expect US interest rates to be over the next couple of years – the so-called dot plots. The chart below compares their forecasts in September and December 2018.

Notably, the median Fed Governor now expects two rate hikes in 2019, down from three in September.

Source: Bloomberg

Compared to the market, the Fed reckons it can maintain its interest rate programme with some vigour as economic growth remains stable. Yet market expectations for the probability of no rate hikes in 2019 has gone from below 20% probability in October to close to 80% today.

So, what’s happened? Well, there’s a certain circularity here.

Investors believe that financial markets are forward-looking – they are, but they can also change their minds. If markets signal weakness, then maybe we should listen.

So far, we haven’t seen much weakness in macro forecasts. The chart below shows consensus expectations for 2019 GDP growth in the US – no sign of weakness there yet. But that makes sense, as forecasts like this will almost always lag.

Higher frequency data tells a less robust story. The chart below shows the Citi Economic Surprise Indicator for the US. A negative number means that macro data is coming in weaker than expected. This indicator has turned negative recently, although it hasn’t been a dramatic move.

Source: BloombergThere are also inflation expectations, and this is where it gets quite interesting.

Long-term inflation expectations have collapsed in recent weeks. The chart below shows US 5 year forward expectations, a measure of long-term inflation expectations. It has fallen from 2.20% to 1.82% in a couple of months.

The US 10 year yield shows a similar picture, down over 60 bps in the past eight weeks. That should catch the Fed’s attention.

Source: Bloomberg

What does this mean for 2019?

Financial markets are telling you that the economy is weakening, as some macro data begins to soften. The current government shutdown in America will probably exacerbate that a bit, we hope only temporarily.

If we continue to see softer data, the case for two rate hikes this year should disappear pretty quickly.

Our best guess today is that we won’t see two rate hikes in the US this year. That could reassure financial markets, unless the economy really grinds to a halt. If the Fed sticks to its most recent dot plot, however, it’s probably bad news for risky assets.

What does this mean for the way we manage portfolios?

Whilst uncertainty can be uncomfortable for investors, we aren’t changing the way we manage portfolios to try and gain short-term wins.

At Moneyfarm, we firmly believe that to maximise your returns, you need time. A longer time horizon allows you to take on more risk, allowing you to expect larger returns, confident you’ll have the time to see out any short-term fluctuations in the financial markets.

But it’s important you do this in line with your investor profile. By taking your risk appetite, financial background and time horizon into account, you can build a portfolio that reflects you and your goals.

The path to your goals might not be straight forward, but it will be within the parameters set by your investor profile, which will help you maximise your returns over the long-run.

This time of year is renowned for reflection, and we certainly look back at the last 12 months with pride. It’s been a busy year at Moneyfarm, and we’ve reached a number of exciting milestones as transitioned into a new phase of growth.

This time of year is renowned for reflection, and we certainly look back at the last 12 months with pride. It’s been a busy year at Moneyfarm, and we’ve reached a number of exciting milestones.

We launched the Moneyfarm Pension, secured a £40 million funding round, opened our Advice Centre, and even expanded into Germany, further cementing our position as a pan-European leader.

Moneyfarm Pension

We launched the Moneyfarm Pension in early 2018 to provide investors with financial security in retirement through the benefit of easy transfers, simplicity and low-cost investment advice.

Moneyfarm’s quick, simple and managed transfer process provides investors with a powerful tool to understand how much they have in their pension and put plans in place to reach retirement goals.

The technology that sits behind the pension product allows us to bring a cost-effective pension solution to those that have been locked out of the traditional wealth management space due to the numerous barriers to entry.

Unlike some pension products, basic tax relief is automatically added to your pension contributions and flexi-access drawdown is a standard feature. This provides investors with the freedom to manage their retirement income according to their needs.

Expansion into Germany

In November, Moneyfarm acquired German digital wealth manager, vaamo. Marking our entrance into our third market, we’re combining our award-winning investment services with vaamo’s foothold in the German market to provide more personalised and innovative investment advice solutions across Europe.

Moneyfarm’s acquisition of vaamo marks an exciting new phase of growth, as we look to combine our European experiences to provide more personalised and innovative investment advice solutions internationally.

Securing the largest funding round of its kind

Moneyfarm secured one the largest European funding rounds in the first half of the year, according to a KPMG report. The £40 million investment is being used to further expand our vision through our advisory service – including goal based investing – products and investment proposition.

The funding round was led by Allianz Asset Management, which has increased its minority stake in Moneyfarm after first investing in us in 2016. Also joining the investment round were venture capitalist firm Endeavor Catalyst and Italian finance firm Fondazione di Sardegna. Further funding from existing backers include private equity firm Cabot Square Capital and initial investor United Ventures.

The funding round marked an exciting phase for Moneyfarm as we expand our customer base through a focus on greater personalisation of the investment advice we give to help support and guide customers along their wealth journey.

We won prestigious awards

2018 was a big year for our awards cabinet, with two prestigious awards taking centre stage.

We won Innovation of the Year at the British Bank Awards, the most widely reporting banking awards in the UK. Moneyfam was shortlisted for the award alongside Wealthify, WiseAlpha, Habito, True Potential Investor, and Revolut.

We were especially excited to win this award as all entrants are subjected to a rigorous judging process based on competitiveness of price and structure. Shortlisted firms are then judged by a panel of over 200 readers who mystery shop each company and benchmark the quality of service provided in each product area.

We’re thrilled to win such a prestigious awards, and excited to see customer support for our product. Technology sits at the heart of our product. However we believe that in combining technology with human empathy and financial expertise we deliver something truly innovative – delivering cost-effective advice and investment solutions to every user.

Merry Christmas from everyone at Moneyfarm

Thank you for choosing Moneyfarm as the financial companion to help you reach your goals. I’m proud of everything the Moneyfarm team has achieved this year, as we continue to empower individuals to make the right decisions with their wealth to ensure financial security in the future.

Understanding how global political and economic events influence your portfolio can give you the confidence to stick to your investment strategy during periods of uncertainty. Here, Richard Flax discusses the events the Investment Team have been monitoring closely.

Investing for your own future takes a lot of time, skill and expertise. It’s not impossible, but it can be difficult knowing you’re making the right decisions with your money when the geopolitical and economic backdrop is uncertain.

Understanding your investor profile and appetite for risk is one of the first steps in building a portfolio that will help your money grow over the long-term. Yet it’s not an easy task identifying your investor profile and deciding how to reflect this and the evolving geopolitical and economic environment through the allocation of assets in your portfolio.

At Moneyfarm, our experienced investment team build and manage the investment portfolios for our investors to ensure they reflect our investor profiles. Whilst we use passive Exchange Traded Funds to build our portfolios, we certainly adopt an active management style.

What volatility means for your long-term returns

When investing, one of the largest barriers to you reaching your goals is diverting from your investment strategy. Short-term fluctuations in the financial markets can make investors feel backed into a corner, under pressure to make an investment decision to avoid losing money.

Volatility is uncomfortable to sit through and it can lead both newer and experienced investors to try and time the market. However, it’s time in the market, not timing, that can really help maximise your returns over the long run.

Look at the chart above as an example, which reflects the performance of the MSCI World Index since 1971. Whilst the annual return has swung from positive to negative over this period, the underlying performance trend of the index has been positive.

If you’d have invested £100 in 1971, you’d have just shy of £2,750 today. By sitting through the worst annual performance of -40% in 1990, and others, your portfolio would have returned 2,650%.

Missing the best days of performance

As the best and worst days in the market are usually clustered around the same time¹, it’s easy to miss the best days of performance by trying to avoid the worst. And this can have a real impact on your overall portfolio performance.

For example, if you’d invested $10,000 on 1 January 1998 and left it tracking the S&P 500 until the 30 December 2017, your portfolio would be worth $40,135, research from JP Morgan shows.

This is more-than double the $20,030 you would have if you missed just the 10 best days in the market. Miss the best 60 days and performance slips to -6% to just over $2,834.

What’s driving markets?

Even when you have a long-term horizon and enlist the experts to manage your investments for you, understanding what’s driving the performance of your investments can give you the confidence to stick to your long-term investment strategy.

Trade tensions

Markets had some light relief earlier this week on news that a trade deal had been agreed in principle between China and the US.

China agreed to increase their purchases of American products, whilst America agreed to halt its increase in tariffs from 10% to 25% on around $200 billion of Chinese goods.

However, talk of a trade agreement may have been a bit premature, especially with the appointment of Robert Lighthizer, to head up the negotiations. He’s unlikely to give China an easy ride.

Then the Canadian government arrested the Chief Financial Officer of one of China’s national technology companies,Huawei. Accused of breaching US sanctions against Iran, the arrest came at the request of the US – although it wasn’t necessarily Trump who made the call.

Extraditing corporate executives is unusual and it’s not far-fetched to assume there will be some form of retaliation if it isn’t resolved. Whilst not directly a trade issue, the move shows the complexity of the rivalry between China and the US.

If the last week is a sign of things to come, the path to trade deal between the pair next year is unlikely to be quiet, and markets are likely to be tested. Even so, we do expect a solution to emerge as China and the US are so economically intertwined.

Monetary policy

The Fed’s path of gradually raising interest rates has come under increasing focus from markets. In November, Fed Chair Jay Powell hiked interest rates, as expected, but it was his commentary that held the takeaways.

Whilst interest rates are still in line to rise in December, the Fed Chair is considering taking his foot of the accelerator in 2019. This will give the Fed more time to evaluate the impact of higher rates. Interest rates may still be low by historical standards, but they’ve gone quite a long way up from the post-crisis trough.

Financial markets pay attention to noise like this, with the S&P 500 rallying and expectations for rate hikes in 2019 weakening. However, this isn’t a dramatic shift in policy from Powell. And even if the Fed were to pause in early 2019, signs of accelerating wage growth could easily cause another shift in view. It’s also difficult to ignore the recent flattening of the yield curve seen in the Treasury bond market.

Brexit

It’s not easy keeping up with the Brexit story, but, as it stands, Parliament is set to vote on Theresa May’s Brexit deal on 11 December. It’s uncertain whether she will win the vote, and what will happen if she doesn’t.

There are three main options in the latter scenario; the deal gets passed in a second vote after markets wobble, parliament takes control of the process with the potential for a second referendum, or a vote of no confidence could trigger a General Election.

As we sit here today, it seems that the probability of no-deal is falling – thanks largely to amendments passed in parliament. That’s good news for UK financial assets, in our view. It probably cuts the downside risk.

What this means for portfolios

Short-term fluctuations are expected when investing in the financial markets. Whilst volatility has picked up, the MSCI World’s yo-yoing has been locked in a trading channel set since mid-October.

Despite geopolitical tensions, there hasn’t been a shift in global economic growth forecasts, which should provide a floor for equity valuations.

We’re currently revisiting our strategic asset allocation, an annual event, and we’ll let you know how our strategy changes. The Moneyfarm portfolios are relatively conservatively positioned at the moment and we think that that makes sense.

If you’d like to talk about the performance of your portfolio, your asset allocation, or have any questions about the market, book a call with one of our Investment Consultants today.

Volatility picked up in October, sparked by increasing geopolitical risk and economic uncertainty. Whilst equity markets felt the pressure, the US earnings season unveiled a solid backdrop, so does this mean US equity is now cheap?

Value, much like beauty, is in the eye of the beholder. But for simplicity’s sake we’ll use the traditional Price/Earnings multiple to measure value. The ratio compares the price of an asset by the earnings it’s expected to generate in the future.

The higher the PE, the higher it’s valued – probably because investors expect strong earnings growth in the future. The lower the PE, the cheaper it is. Whether that means it’s good value is a different question, and one we’re going to look at here.

It’s never good to judge something by looking at a snapshot of performance in isolation – just like we don’t base our investment decisions on the PE alone.

Here, we’ve compared the PE ratings of a range of equity markets over the last decade: Emerging Markets (blue line), US (yellow line), Europe (red line) and the UK (turquoise line).

Broadly, you can see a steady rerating as the PE ratios for each market rises up to mid-late 2017. The UK, however, sticks out with the PE under immediate pressure following the Brexit vote.

So US equities are trading for less than they were, but does that mean they are cheap? The chart below shows that whilst the US market has had two meaningful sell-offs in 2018, valuations are still sitting above the 10-year average.

We’re always monitoring the markets to ensure we’re aware of value opportunities when they arise. In Europe, equity valuations are roughly in line with the 10-year average, and are back at 2013 levels.

We see better value in Emerging Markets, with equities approaching one standard deviation away from the long-term average PE. Although EM equities have been in this position before, and even lower, there’s more valuation support today then we’ve seen in the past.

And, finally, the FTSE 100 – which, as we noted above, started to de-rate after the Brexit vote in 2016. Looking at the PE alone, the FTSE doesn’t look super-cheap – only slightly below the long-term average – despite a decent amount of commentary. That’s partly because we’ve used a 10-year average as a comparison.

If you were to use a five year average (as in the chart below), the FTSE does begin to look rather cheap versus history.

Valuation is a pretty good signal of long-term returns, which is why it plays a prominent role in our Strategic Asset Allocation process. But it’s less good at predicting short-term returns. At this point we can say that equity valuations look better than they have but in general aren’t very cheap compared to a ten-year history.

As the PE is composed of the Price (which we know) and Earnings (which we estimate), we have to judge how accurate those earnings estimates are. In 2017, expected earnings drifted higher over the course of the year, which helped push equity markets higher.

In 2018, the results are more mixed. US earnings expectations have gone higher, at least for now, while non-US earnings expectations have drifted down.

The chart below captures this. It shows how current year earnings expectations have moved. European and Emerging Market earnings have been steadily downgraded, whilst the US and the UK (more interestingly) have seen upgrades. In the short-term, the case for UK equities looks better with this earnings outlook – even if some of it is probably related to a weaker sterling.

Leaving short-term earnings to one side, the question of corporate profitability is an important one. Much has been written about how recently returns have been skewed towards owners (capital) as a opposed to workers – giving rise to populism.

The chart below tries to put this in some context. It shows corporate margins (operating and net margins) over time. The first thing to note is that margins have been cyclical over the past twenty years. In a recession, we see margins fall. That’s not really surprising.

The second thing is that margins are getting close to the historical peak of 2007. And this, rather than valuations, is probably the bigger risk for equity markets going forward.

What can you take away from this research?

Global valuations look cheaper, but not cheap.

Emerging Markets look closest to showing long-term value.

The UK looks a bit more appealing compared to the last five years, but Brexit colours the debate.

Earnings revisions have been mixed – with the UK and US looking a bit better.

Corporate profitability looks high versus history – if we see the global economy weaken that could translate into lower corporate profits, slower growth and further pressure on valuations.

The global backdrop is complex, but we monitor the markets daily on your behalf to ensure your portfolios reflect your investor profile and are positioned in the best way to help you reach your goals.

The Investment Committee was happy with the more conservative positioning of the Moneyfarm model portfolios at the latest rebalancing.

After careful consideration, we decided to use the rebalancing to control the volatility of the portfolios in line with historic levels. We’ve managed portfolio volatility through our overall equity exposure, which we reduced.

It can be tempting to want to change your risk level in response to market volatility, but your investor profile and risk appetite is based on you, not the external environment. By building your portfolio to reflect your appetite for risk, you can help mitigate external risks for effectively when they arise.

As we navigate potential trade friction, Brexit, increasing Eurozone tensions, and tighter monetary policy, threats to the global economy have been reflected in a recent downgrade to IMF growth expectations.

The global backdrop is complex. We monitor the markets daily on your behalf to ensure your portfolios reflect your investor profile and are positioned in the best way to help you reach your goals.

It can be tempting to want to change your risk level in response to market volatility, but your investor profile and risk appetite is based on you, not the external environment. By building your portfolio to reflect your appetite for risk, you can help mitigate external risks better than having a reactionary investment strategy.

It’s important to remember after periods of such low volatility, that this dynamic is a normal part of the financial markets and can be managed in line with your investor profile.

We’ve pulled together this handy guide of the most common questions investors ask during market volatility, answered by our Head of UK Investment Consultants, Will Hedden.

Equity markets

Whilst uncertainty in this climate has been around for some time, markets are starting to acknowledge it in their valuations. The belief that Central Banks will be on call in difficult situations with stimulative measures is being weakened by hawkish rhetoric from policy-setters.

Recent volatility has unwound some of this growth and as we move into the final months of the year, this momentum could begin to slow. Equity markets have been expensive for some time, but these lofty earnings-based valuations have been supported by strong corporate profitability.

US Share BuyBacks and tax cuts played a big role in supporting valuations this year, but they not be as influential in the future.

Despite the potential for challenges that lie ahead of US Equity, we have a positive outlook on the market. Earnings growth is expected to outstrip momentum in Europe, especially as political tensions increase in the region ahead of election season.

Trade concerns, the tightening of monetary policy in developed markets and the dollar’s appreciation also heightens risk in Emerging Markets.

In higher risk portfolios we reduced our exposure to Asia and Pacific Developed Equities, and have reduced our overweight European Equity position, favouring US equity instead.

What has changed in Moneyfarm portfolios

Whilst the clouds have started to form on our outlook, the Investment Committee was still happy with the more conservative positioning of the Moneyfarm model portfolios.

After careful consideration, we decided to use this rebalance to control the volatility of the portfolios in line with historic levels. We’ve managed portfolio volatility through our overall equity exposure, which we reduced.

We’ve also increased exposure to Sterling Cash, to boost liquidity and generate a small yield without adding risk.

In terms of foreign currency exposure, we have increased the sterling exposure, mainly by selling US Dollar, and Emerging Market currencies in some higher risk portfolios.

Moneyfarm portfolios have benefited recently, on balance, from an exposure to non-sterling currencies. Whilst we want to maintain USD’s hedging properties, we also want to control our levels of volatility and limit any downside in the event of a Brexit scenario that favours sterling.

These rebalancing adjustments have shifted exposure slightly away from equity, in line with the risk profiles of our investors, and increased the portfolios’ sterling exposure.

If you’d like to discuss the performance of the model portfolios or want to know the thinking behind the Moneyfarm investment strategy, please call your Investment Consultant on 0800 4334574.

Discussions about performance and how to measure it are normally left to those with specialised knowledge. Yet the way we calculate performance has a real impact on you, our customer, and the investment decisions you make in pursuit of your financial goals.

There are a number of different ways to measure performance, although there’s no one correct method alone. Here’s a quick guide to how we measure the performance of your portfolio at Moneyfarm.

Simple calculations

Strip out cash flows (both investments and withdrawals) and simple performance calculations compare the market value of your portfolio against its initial value.

Imagine you invested £10,000, which grew to £10,500 in one year. The performance of your portfolio is +5%. If you’d invested £10,000 and ended the period with £9,500, your performance would be -5%.

It’s certainly easier to understand simple calculations and use them to make comparisons between wealth managers, but introduce cash flows – both in and out of the portfolio – and the way you measure performance gets a bit more complicated.

In the example above, if you invest another £10,000 and the value of your portfolio becomes £20,500, the simple return falls to 2.5% without any market movement at all.

For a more accurate and fair representation of performance, wealth managers typically debate between two preferred measures; time-weighted performance and money-weighted performance.

Time-weighted performance

A time-weighted method of reporting strips out the impact of cash flows on performance. It does this by separating the reporting period into subperiods based on the timing of cash flows.

For example, if you invest £350 every month for a year, the annual reporting period would be split into 12 sub-periods. These sub-period performances would then be linked together to show an annual performance.

All reporting periods are treated equally in the time-weighted calculation, even if you invest different sized lump sums an an irregular basis.

By eliminating or reducing the impact of cash flows, time-weighted performance is preferred by many wealth managers who have no control over the cash flows of the individual investor. To them, it better reflects their ability. However for the individual investor this isn’t the whole picture.

Money-weighted performance

Another way to calculate performance is with a money-weighted calculation. This measure is seen as a more accurate picture of the true return you receive as an individual, as it includes individual cash flows within a period – whether dividends, account top-ups or withdrawals.

This measure of performance corresponds to a well-known concept in finance called the internal rate of return (IRR).

Investing or withdrawing from your portfolio impacts the performance number, especially during times of volatility. This means the performance figure of your portfolio is more exposed to your cash flows than the ability of your portfolio manager.

Does it matter how your performance is calculated?

During periods of volatility, it’s important investors understand how their performance is calculated. Different reporting styles can show significant differences during periods of volatility or if there’s a large cash flow during a reporting period.

Understanding this and looking at the whole performance picture can help investors avoid any ill-timed knee-jerk reactions that can be more detrimental to portfolio performance over the the long run.

The chart below shows just how significant this difference between time-weighted (blue line) and money-weighted (orange line) can be, especially when compared to the portfolio value (grey line).

In the first few months of this reporting period, performance of both money-weighted and time-weighted performance are nearly identical. Two large inflows in the beginning of 2017 cause this to change quite quickly.

You can see periods of volatility are exacerbated in the money-weighted calculation. Whilst the time-weighted figure is also impacted, it’s not as severe as the money-weighted measure, which falls from nearly 12% to 3% during market volatility.

Crucially the portfolio value doesn’t react as violently to market volatility. Importantly, this is disguised by the swings in performance measures.

At Moneyfarm, we currently use money-weighted Performance as we believe this provides you with a fair reflection of what’s happening to your money. But we’re committed to providing you with a transparent picture of how your investments are performing, and are working towards providing multiple methods of performance calculation on the dashboard in the future.

Volatility can be unnerving if you’re not invested in the right way for you. Remember, it’s a normal part of the financial markets and is the dynamic that gives investors the opportunity to grow money in the first place.

Investment advice ensures your investments are suitable your risk appetite. If your portfolio reflects you and your time horizon, stick to your long-term strategy and avoid reacting to any short-term fluctuations. If you have any questions about recent performance, book a call with one of our Investment Consultants who will be in touch soon.

If you have any feedback about the way we show the performance of your portfolio, please get in touch at hello@moneyfarm.com.

]]>https://blog.moneyfarm.com/en/investments/calculate-performance-moneyfarm-portfolio/feed/0Market update: Why August was an important month for marketshttps://blog.moneyfarm.com/en/financial-markets/market-update-august-important-month-markets/
https://blog.moneyfarm.com/en/financial-markets/market-update-august-important-month-markets/#respondFri, 07 Sep 2018 16:10:11 +0000https://blog.moneyfarm.com/en/?p=6860

Financial market participants are usually a bit nervous in August, fearful their holidays will be ruined by a significant financial market event. Most of them will have let out a sigh of relief as they emerged into September relatively unscathed. August was still an important months for markets, as the UK continued to try and […]

Financial market participants are usually a bit nervous in August, fearful their holidays will be ruined by a significant financial market event. Most of them will have let out a sigh of relief as they emerged into September relatively unscathed.

August was still an important months for markets, as the UK continued to try and negotiate its exit out of the EU, emerging markets reacted to a tightening monetary policy landscape, and Italian politics stole European focus once more.

Global markets in August

Global markets had a mixed month in August; whilst the US performed relatively well, there was weakness in the UK, Europe and Emerging Markets. Some of this pressure on export-led economies will have been stoked by concerns over trade policy.

Turkey and Argentina had a tough month, although they make up a relatively small part of the emerging market equity universe, but it’s certainly a sign that there is a broader concern around what tighter US rates might mean for countries that have very large trade or current account deficits.

Preparing portfolios for Brexit

Moneyfarm generally has the view that a Hard Brexit, or a no-deal Brexit, will be seen as negative for financial markets, triggering further weakness in sterling and UK assets more generally.

We also acknowledge there is an upside scenario; this could be a second referendum –however unlikely that might be – or perhaps Theresa May could negotiate a deal that the market takes well.

When we’re building the Moneyfarm portfolios, we want to make sure we capture the upside scenario, but also protect ourselves from the downside as best we can.

The Moneyfarm portfolios are currently fairly balanced in terms of sterlings vs non-sterling exposure, depending on their risk level. Our Asset Allocation Team monitor the markets and economic events daily, and will make the necessary adjustments to portfolios when there is greater clarity on the final outcome.

The Italian Budget

The focus in Europe was really on Italy in August, and specifically the Italian Budget. The government has made no secret of the face that it wants to increase spending, despite debt levels already being very high, and Italian bond yields have risen as a result.

UK portfolios don’t have a great deal of Italian exposure, but this question could have a wider impact of European markets more broadly over the next few months.

Not many people would turn down the chance of market-beating returns from their portfolio, but it takes a lot of analysis to judge whether an investment will help you reach your targeted return. Find out how calculating alpha could help.

Not many people would turn down the chance of market-beating returns in their portfolio, but it takes a lot of analysis to judge whether an investment will help you reach your targeted return. A measure often used to help people value an investment is alpha, but how is it calculated and what does it show?

What is alpha?

The first thing to understand is that alpha is a vague concept – as is often the case when evaluating the performance of a fund or strategy.

Broadly speaking, alpha reflects the ‘active’ return of an investment against a benchmark. Active management is a strategy where a fund manager tries to outperform the wider market or the benchmark it closely correlates with.

For example, imagine Fund A returns 5% over 12 months, outperforming the 4% growth on the benchmark. In this instance, you would describe alpha as 1%.

To generate alpha, a fund manager needs to have faith in their ability to time the market to buy and sell investments at their most profitable time, and select the single securities they believe will outperform the market.

Alpha and financial theory

The use of alpha as a statistical measure derives from:

Modern Portfolio Theory (MPT), which outlines the relationship between risk and return

Capital Asset Pricing Model (CAPM), which first introduced the concepts of Alpha and Beta

Pioneered by Harry Markowitz, MPT suggests there’s an ‘efficient frontier’ of portfolios that offer the maximum expected return for a given level of risk.

When thinking about risk and how best to manage it in your portfolio, it’s useful to decide whether it can be described as systematic – also known as market or un-diversifiable risk – or unsystematic – also known as specific risk, which can be managed better through diversification.

How can you measure alpha?

A fund manager decides how much risk to take, which is represented by the beta. A beta of 1 means taking on as much risk as the broader market, and the same returns should be expected. A beta of below 1 means taking on less risk than the general market.

A beta that’s higher than 1 means the fund manager is taking on more risk and thus should expect greater returns. It’s important to separate whether any active returns above the market represents the extra risk that was taken or the fund manager’s skill.

Jensen’s alpha

Alpha is usually stated in a single number, which reflects how well an investment has performed compared to its benchmark. The basic alpha calculation simply subtracts the total return of your investment from the return of the benchmark.

There’s a more advanced technique called Jensen’s alpha that includes Capital Assets Pricing Model (CAPM) theory, and calculates the risk free rate and beta.

Outlining the relationship between risk and return, CAPM is used to price risky assets, estimating the expected return for a given level of risk. In line with CAPM, to calculate Jensen’s alpha in a portfolio you need to know:

R(i) – realised average return of the portfolios

R(m) – the realised return of the benchmark

R(f) – the risk-free rate of return

B – the portfolio’s beta

You’ll plug these numbers into the following equation to calculate the alpha:

Excluding any market impact, alpha will be zero – if CAPM is correct.

If the alpha isn’t a positive figure, the fund manager wouldn’t have earned enough return for the amount of risk she was taking. A positive outcome means the portfolio is earning excess returns compared to its benchmark in an uncorrelated way.

The difference between Jensen alpha and standard alpha is that the former allows to evaluate the consistency of the excess return.

For example, assume you’ve invested in two funds; Fund A and Fund B. Both funds have the same level of standard alpha in the last year but performed quite differently.

Fund A performed below its benchmark for the entire year except for one day, where the performance was so strong it pulled the overall alpha of the year to positive. Fund B had a positive and systematic excess return over the benchmark each day of the year.

Understanding the risk/return relationship, which fund would you be more comfortable investing in?

In this example, Fund B would have had a more statistically significant alpha performance than Fund A, and perhaps a more reliable investment.

What are the problems with alpha?

As with any theory, alpha is by no means infallible.

It can be quite difficult to find a comparable benchmark to assess the performance of your portfolio. But you need to chose this wisely to get a true reflection of the value active management has brought to your portfolio.

When there’s no suitable benchmark, analysts can now use algorithms and other models to simulate an index just for the purpose of calculating alpha.

Alpha versus efficient market hypothesis

Those who question the validity of alpha, may fall into the efficient market hypothesis (EMH) camp, and believe that any risk adjusted excess return is generated by luck rather than skill.

EMH suggests the market has already priced in all available information, so is accurately valued. This would mean active managers don’t necessarily have an elusive edge over anybody else.

No matter whether you think generating market-beating returns comes down to skill or luck, we do know it’s near-on impossible to beat the market every year, and some active funds have been struggling. Two-thirds of large-cap active fund managers failed to beat the S&P 500 in 2016, according to the S&P Dow Jones Indices.

Smaller asset managers had a tough time too, with 90% of mid-cap and 86% small-cap managers missing the mark.

Under scrutiny by investors and the industry alike, active managers got some of their mojo back in 2017, with just over half of equity funds outperforming their benchmark in 2017, up from 23% in 2016, according to research firm Scope Analysis.

At Moneyfarm, we have nothing against active investments, but we do have a problem with the fees investors are often required to pay for active management. Overly expensive fees can damage performance and delay investors from reaching their goals.

The more money you can keep invested in the market, the better, as you can maximise your returns through compound interest. This is where your returns are reinvested to earn their own returns, and can make a real difference over the long-run.

It’s crucial investors understand how fees impact performance. Whilst you can never guarantee a return from your investments, you can control how much you pay in fees.

Active decision-making

Of course, when it comes to passive investments, if the benchmark a fund is tracking falls in value, so will the fund. This means it’s doing its job correctly.

That’s why Moneyfarm builds investment portfolios that are diversified across asset classes and geographies to manage this risk. Diversification looks to offset any losses in your portfolio with gains made elsewhere.

You might want to invest in passive instruments to maximise your returns by reducing costs, but you can include an active decision-making strategy to build your portfolio in the best way to reflect your investor profile.

Our team of Investment Consultants can assess the impact fees are having on your portfolio, just book a call for a portfolio review.

ETFs are simple investments, but picking the right mix to help you reach your financial goals is difficult. Find out how our Asset Allocation Team use their skill and knowledge to ensure the ETFs we pick are best suited to you.

At Moneyfarm, we use Exchange Traded Funds (ETFs) to build our investment portfolios. Although they’re simple investments, picking the right mix to help you reach your financial goals is more difficult. This is where our experienced fund managers headed up by Chief Investment Officer Richard Flax use their skill and knowledge to ensure the ETFs we pick are best suited to you.

What is an ETF?

An ETF is a fund that tracks a market index (like the FTSE 100 or S&P 500), specific commodity, bond, or even a basket of assets. In an ETF that tracks an index, the fund will essentially own shares and trade them to reflect moves in the index they’re tracking.

ETFs can be traded just like individual stocks, but because they’re based on an underlying index or investment, they offer more diversification than individual shares. As ETFs don’t involve active management, they are lower cost than traditional investment funds.

Active management with passive investments

ETFs are passive instruments, which means they track markets rather than seeking to outperform them. It’s important to note that this doesn’t mean an investment portfolio based on ETFs involves no active decision-making.

Far from it. The enormous choice of ETFs – which some say now outnumbers individual equities – gives investment managers many opportunities to refine and tune portfolios.

Most of Moneyfarm’s equity ETFs are weighted by exposure to market capitalisation, but we make an active choice in deciding which benchmark to use. Should it be an ETF that weighs all stocks in the index equally, or one that sorts companies by profitability?

In our view, investors currently have a wider choice at a lower cost than traditional active fund management. Although Moneyfarm uses passive instruments, we don’t take a passive approach to investing.

So our selection process is incredibly important to ensure we’re building the right portfolios to help our investors reach their financial goals. Investing with Moneyfarm isn’t a case of picking a single index to follow.

Moneyfarm’s strategic portfolios are built with a 10-year view. We develop forecasts about returns that reflect long-term expectations about the global economy and financial markets.

We also need to think carefully about the way different financial markets interact with each other, as these dynamics are important considerations for building well-diversified portfolios.

Whilst our strategic view looks out to 10 years, we know the journey there won’t necessarily be smooth. To optimise the risk/return profile of our portfolios, we put a tactical overlay on our strategic asset allocation, which is Moneyfarm’s rebalancing process.

The Investment Committee meets every month to discuss market and economic trends, review risk management and volatility, and make tactical allocations where necessary.

How we select ETFs

Moneyfarm’s experienced fund managers monitor the markets every day, evaluating thousands of ETF products listed on the London Stock Exchange in line with market trends.

We score ETFs by asset class, according to the following criteria:

Underlying index

Fund liquidity and size

Replication strategy

Performance

Cost of ownership

Lifecycle

Security lending

Issuer quality

We believe diversification is important to manage the sector-specific risks in our portfolios, so we build our portfolios with globally diversified ETFs. This ETFs include exposure to

Cash equivalents – Low risk, low return but can be a good source of income

Emerging markets equities – More volatile than developed markets, but offer the potential for higher returns

Commodities – A good diversifier and hedge against inflation

Real estate – Can provide a steady income and tends to keep pace with inflation, but has low liquidity, high transaction costs, and requires management.

The two main asset classes in our portfolios are equities and bonds. It’s important we value these carefully and accurately to build our forecasts and understand the role they’ll play in your portfolios.

How to value equity

Equity return is comprised of two main components; dividend yield and price appreciation, both of which are affected by earnings growth and economic conditions.

To forecast the expected share price performance,we use the Cyclically Adjusted Price to Earnings (CAPE) ratio to value equities. CAPE is a valuation tool used to assess future equity returns and is defined as the price of an asset divided by its earnings.

To compute CAPE, we calculate 10 years of historic corporate earnings and consumer price indices (inflation) for the main geographical areas (United States, United Kingdom, Japan, Eurozone and Emerging Markets). It’s important that we adjust these historic earnings to ignore the impact of inflation before computing the CAPE series.

The underlying assumption of our method is that in the long run, an equity market’s CAPE will converge to its long-term median. By comparing the current CAPE level to the long-term average, we can estimate its path (mean reversion) back to the median.

How to value bonds

To estimate the returns on a debt security, we start by looking at its price. This is best conveyed in its yield to maturity (YTM).

The YTM is the total expected return, assuming the bond is held to the end of its life, and includes any coupon pay-outs (income) and the final repayment. In other words, it’s a bond’s internal rate of return.

Starting with the current YTM of a security (a 10-year German government bond, for example) we then add real GDP growth forecasts and the long-term inflation outlook. We then add the Term Premium (the excess yield required for holding a long-term bond), assuming it will go back to the 10-year median level.

To model the current low interest rate environment, we introduce a financial repression factor to get an estimate of the YTM in 10 years’ time. We assume the Actual YTM will linearly reach the Expected YTM in 10 years to calculate the long-term expected return.

This is just an overview of the essential due diligence we go through to build your investment portfolios. This is a full time job for us, and it may feel like a second job if you’re doing it yourself – but you can’t compromise on this analysis.

The good news is that whether you work in finance during the week and don’t want to do it when you get home, you’re too busy juggling the school run with your career, or maybe you’re just not that interested in the financial markets, you don’t have to do this hard work yourself.

Role of technology and human expertise at Moneyfarm

Wealth management is changing. Today, technology has put more personalised advice and higher-quality products within the reach of more people.

When you join us, all you need to do is complete a simple questionnaire. Once we understand your financial situation, our technology matches you to an investor profile that’s based on what you’re saving for, when you’ll want your money and your financial background.

Next, you’re paired with a portfolio that our team of investment experts have carefully built and will continue to manage right up until you decide to take your money – whether that’s for your child’s wedding, career change, or your dream retirement.

It’s important to know that whilst we make maximum use of the latest technology to keep costs down for you, a great deal of thought and expertise goes into the decisions we take.

If you’ve got any questions on our Investment Strategy, you can get in touch with one of our qualified Investment Consultants, or subscribe to watch our Monthly Market Updates with CIO Richard Flax on our Youtube Channel.

When you want to give your money the best chance to grow, security is important. It’s important to us at Moneyfarm, too. We work hard to ensure the investment process runs smoothly for our investors, to give you peace of mind.

You know that to grow your money to reach your financial goals, you need to take on a little risk.

And you’re happy taking on the right amount of risk for your investor profile.

Of course, this means the value of your investments can go up and down, and that’s a crucial dynamic of the financial markets that allows you to grow your money over time. Anyway, investing with a long-term horizon allows you to ride out any short-term volatility.

It’s important that you’re confident that we at Moneyfarm are doing everything we can to keep your capital and data safe.

It’s the responsibility of our Operations team to ensure the investment process runs smoothly for our investors across three main areas; onboarding, cash management, and reporting and billing.

But what does this entail for our Operations team? Find out in this video as Client Assets and Operations Manager Olga Arora and Head of Operations Tomaso Papetti explain how they keep your capital and date safe for as long as you invest with us.

There’s a great responsibility that comes with dealing with your money and we take that extremely seriously.

No matter whether you invest £10,000 or £1 million, our job is to put you at the heart of your investments and allow you to focus on the important things in life, knowing the experts have your back.

It’s too difficult to monitor each investment within every market – there are over 2,600 different companies listed on the main market of the London Stock Exchange alone. Luckily, investors can judge sentiment through the eye of an index.

An index is essentially a list of investments selected to represent a sector or region. By looking at the performance of an index, investors can assess the health of a market and use it to inform important investment decisions. Indices are also used as key benchmarks to compare investment performance.

Reflecting sentiment within a market and tracking performance, indices have improved transparency and have made the inner workings of the financial markets easier to digest.

You can easily gauge how investors feel about global events, identify when markets are in a bull or bear phase, and make crucial international comparisons – essential for when you want to build a globally diverse portfolio.

With many indices reaching multiple record highs over the last two years and outperforming some funds that had been carefully selected by fund managers, many people wanted to actually invest in an index rather than just use it as a benchmark.

The history of the index

The first index was created by founder of The Wall Street Journal Charles Dow in 1896. Wanting to provide investors with information about stocks during a highly speculative post-recession market, the journalist decided to build the Dow Jones Industrial Average, which monitored the 12 largest companies in the US.

Dow kept the calculation simple, he added up the price of each constituent of the index and divided it by 12 to show the average. Today, the Dow Jones covers 30 stocks and is less concentrated on the industrial sector.

In general, indices are usually calculated by the member’s market value – the value of all the shares on the market. The larger the company’s market value, the bigger its percentage of the index – higher its ranking.

Today, there are a number of indices covering the global markets, including the US S&P 500, French CAC 40, MSCI family and London’s Footsie series – FTSE 100, FTSE 250 and FTSE 350. You can also get indices that reflect the bond markets and other global investments.

Investing in an index

Whilst there are a number of prestigious indices like the S&P 500 and FTSE 100 that are monitored by an army of analysts around the globe, anyone can create an index – it really is just a catalogue of investment names.

Unfortunately, as it’s essentially just a list, you can’t actually invest in an index, and recreating it in your portfolio would take a lot of time and capital – not only are you going to need to cover the trading costs of buying each investment on the index, but you’re going to have to put enough money in to benefit from the diversification.

Exchange Traded Funds (ETF) are popular with investors looking for low-cost diversification in their portfolio. ETFs are a type of passive investment that track an index or group of investments, often replicating an index.

An ETF will buy the underlying assets of the investment it wants to track. If it’s an index, it will buy all the shares in that index, usually replicating the proportion of their market capitalisation. This fund is then sold on the market with a set number of units.

For example, if an ETF tracked the S&P 500, it would mirror the constituents of the US index and would adjust portfolio weightings when appropriate. ETFs don’t guarantee returns, what they aim to do is deliver the same return as the market.

A diversified portfolio across regions and asset classes can help smooth out returns during volatile markets. If some investments in your portfolio come under pressure, gains made elsewhere should level out the performance.

ETFs are simple investment vehicles. As they’re traded over an exchange, they act like a share on the stock market. ETFs have a bid and ask price – the point at which a buyer wants to buy and a seller wants to sell. Their price fluctuates throughout the day as they are bought and sold by investors. Importantly, you can trade an ETF in seconds.

The advantages of investing in an ETF

With the asset management industry feeling the heat from margin pressures, increased regulation and competition, ETFs have surged in popularity.

Assets invested in European-listed ETFs and products reached $802 billion in 2017, according to data provider ETFGI. Although this is still a small segment of the $4.8 trillion global market, it’s the fastest growing, with 40% growth year-on-year.

So, why are ETFs so popular with investors?

Diversification – diversification allows you can manage the risk in your portfolio by spreading your money across different investments. ETFs recreate the investments in an index, for example, which are diversified by their very nature.

Low-cost – their passive nature makes them low-cost investments. The less you have to pay in charges, the more money you can keep invested to benefit from compound interest

Transparent – you can see what you’re invested in at any time, this isn’t always the same for actively managed funds

Liquidity – it’s important you know how easily and quickly you can turn your investments into cash, without this impacting the overall value of your investment.

Flexibility – trading ETFs on an exchange means you can enhance your strategic asset allocation and make the most of shorter-term trends

How to invest in an ETF

Although investing in ETFs is as simple as buying and selling stocks and shares on a DIY investment platform, it can be difficult constructing your portfolio in a way that suits you and your financial goals.

The composition of the investments within your portfolio should reflect your risk level and the market conditions of the time.

Strategic asset allocation defines the long-term goals of the portfolio, whilst the tactical strategy makes the most of any alternative options along the way. ETFs can be used as the crucial building blocks of your portfolio to reach your long-term goals, whilst their flexibility and liquidity means they can make the most of shorter-term market trends.

When you’re picking which ETFs to include in your portfolio, you need to look at the benchmark it’s tracking and monitor its efficiency. How much will it charge you in fees? What’s the tracking difference or volatility of its performance? You also need to make sure you’re getting the diversity you’re paying for.

The ETF universe is huge, and your options are growing by the day. It can feel intimidating when you’re trying to pick the best investments that will help you and your family.

Investing by yourself takes in-depth knowledge, skill, and quite a bit of money to do successfully. Many investors prefer to give their money to the experts to invest for them.

At Moneyfarm we provide our investors with cost-effective regulated investment advice to ensure we’re offering the best investment solution to our customers to help their money grow.

After getting to know more about you, your financial background, your appetite for risk and financial knowledge, we assign you an investor profile that acts a bit like your investor DNA. We then match you to a portfolio that reflects your investor profile, time horizon, and risk profile.

We build and manage your portfolios, rebalancing them to keep it in line with your requirements. We use ETFs to build out portfolios, to provide a low-cost, transparent, flexible and efficient investment solution to our customers.

Once you invest your money, you can focus on the important things in life. Our team of experts monitor the markets daily on your behalf, analysing any investment opportunities, and executing trades – you don’t need to do a thing.

You’re looking to grow your money for the future, but recent market movements have made you question whether now is the right time to invest. Correctly timing the market is a huge challenge for even the most experienced investors, which is why you should look to maximise your returns through the simple strategy of pound cost averaging.

The start of 2018 was characterised by the return of volatility to the financial markets after a surprisingly benign couple of years against growing uncertainty on the global stage.

Whilst volatility has since calmed down, international uncertainty – both financial and political – is still there, and arguably always will be. This shouldn’t necessarily change the way you invest, however.

Can you time the market?

Correctly timing the market is one of the biggest challenges facing investors. To generate meaningful investment returns you would ideally invest when the market is at its lowest and sell when it is at its highest.

But timing trades isn’t easy; it requires constant monitoring of financial markets, the skill to respond to such events, and enough spare cash to cover the high cost of regular trading.

Even the best-known fund managers and investors believe it’s almost impossible to time markets perfectly. Warren Buffett once famously said: “We continue to make more money when snoring than when active.”

Investors are left asking themselves two questions: how do we avoid putting our long-term investment goal at risk, and what can we do to improve the chances of entering the markets at the right opportunity?

Pound cost averaging

One way to work around market timing is to take the little and often approach to investing, rather than investing a lump sum in one go. This strategy can be particularly beneficial during a time of turbulence and uncertainty.

Pound cost averaging is a technique where you make investments on a regular basis and therefore average the price you pay for the total investment over time.

Most investment instruments, such as single name equities, exchange-traded funds (ETFs) or open-ended mutual funds, are available for purchase through regular savings plans (such as ISA schemes) allowing investors to invest on a regular (such as monthly) basis.

At Moneyfarm, our regular investment plans of £400, £800, and £1,600 are popular with investors. Find out what impact these plans could have on your ISA savings and retirement income.

The key benefit of regular investing by setting up a direct debit is that you can avoid market speculation whilst also ironing out the fluctuation of an asset’s price over time, therefore, taking away the worry of finding the right time to invest.

To illustrate this strategy, we have simulated the result of a monthly contribution investment approach in comparison with a lump sum approach when making the same investment.

Let’s assume that an investor wanted to increase their exposure to the UK equity market by investing £13,000 in a UK stock ETF from June 2017. The investor can either invest the lump sum at the start of the period, or choose to make monthly contributions in equal tranches at the start of each month over the next year to average out the purchasing cost.

By making monthly contributions whilst investing in a volatile and falling market, such as in the early start of 2018, the investor bought more shares at a lower price (£6.25 per share and 2,081 shares in total).

If the individual had invested the total amount at the start they would have paid £6.60 per share and 1,969 shares in total. This is equivalent to a discount of 5.4% in price terms and will ultimately boost performance of the portfolio when markets recover.

However, making regular investments over time in a rising market can also lead to a higher average cost of purchase compared to investing the lump sum at the start.

Building a strong portfolio

Building an investment portfolio that reflects your investor profile, appetite for risk and time horizon puts you in the best position to protect or grow your money during times of uncertainty. If your goals are in the near future, you’ll prioritise protecting the value of your money, whilst longer-term goals like retirement will focus on growing it.

By reflecting these needs in the mix of investments in your portfolio, you can ensure you’re in the best position to reach your goals.

This can be quite difficult to do yourself, which is why we’re committed to providing cost-effective investment advice to all our investors. We’ll match you to an investment portfolio that reflects you, your financial background and your financial goals, and our experienced fund managers will continue to manage this for as long as you invest with us.

This means the hardest decision you have to make it how much and how often you want to invest. Setting up a direct debit makes this even simpler.

In general, a pound cost averaging strategy provides more flexibility as you can avoids the opportunity cost of committing a large sum of cash at the start of the investment period. Investors can build a strong portfolio by investing little and often.

Establishing a disciplined and regular investment pattern is a great habit for UK savers at any time. In doing this, you take the emotion and speculation out of the investment process and returns will be smoother amid market volatility.

Hindsight, they say, is a wonderful thing. Understanding a situation and the events that led up to it can help you make better decisions in the future. It’s always good to learn from the past, especially when investing, but hindsight bias could be doing more harm than good when it comes to your investments.

When you look back at certain points in your life, there are probably situations you would like to go back and react differently to, given half the chance.

Return to that point in time, and you might say yes to that risky job opportunity, put an offer down on your dream house more quickly, or hold onto your investments through short-term volatility.

Whilst it’s good to look back at a situation and the sequence of events that led up to it, it can be easy to assume an outcome was more predictable than it actually was.

This is known as hindsight bias, and is a behavioural phenomenon that’s particularly pertinent in the investing world.

Hindsight bias can lead to incorrect analysis of situations, and can influence behaviour in a way that can hurt investor returns in the future through overconfidence.

Hindsight bias when investing

When you invest, you want to buy an asset at a low price and sell it for a higher one. You pocket the difference as a profit, once you’ve taken out the impact of inflation and cost of trading.

When you’re managing your money for the future, you’re under pressure to spot market trends and react to them in the right way. Failing to recognise or understand market trends early enough can lead to regret, which could magnify behaviour later down the line.

Hindsight bias and the financial crisis

After the 2008 global financial crisis, for example, analysts and commentators poured over the small events, repackaging them as the obvious signposts directing investors along the road towards financial strain.

The truth is, however, if these signs were really so obvious, a financial crisis could probably have been avoided.

Hindsight is especially popular after periods of financial strain or crises. The perceived understanding hindsight brings can be more comforting in periods of uncertainty that admitting you don’t know what’s going on.

What’s wrong with hindsight?

It’s not the concept of analysis and review that makes hindsight bias a dangerous habit to form, it’s the overconfidence it brings. Overconfidence can impact your ability to make objective valuations, especially if you think you’re gifted with the ability to predict the future.

Before you start investing, it’s important you build an investment strategy that’s designed to help you reach your goals.

It’s this strategy that removes the personal hunches and gambling aspect of investing, and helps you make the right investment decisions.

Valuing an investment

To ensure your investment strategy is stringent enough to manage risk properly, you will need to:

Develop long-term forecasts for the economy and financial markets to outline the strategic asset allocation of your portfolio

Optimise this asset allocation to build a portfolio designed to reflect your investor profile, tolerance for risk and time horizon

Enhance the risk/return profile of your portfolio with a tactical overlay as part of the rebalancing process

It can be easy to get carried away with a gut feeling, but instead investment decisions should be made on data to ensure they are as reliable as possible. Analysts have stringent due diligence processes to value investments and markets and forecast returns.

Here, we outline common investment calculations used by analysts for to build financial market forecasts for equities and bond markets.

Equity

Professor Shiller’s Cyclically Adjusted Price Earnings model (PE) is a traditional valuation model that looks at an asset’s price compared to its earnings.

The simple calculation goes like this: Price/Earnings = PE

It reflects what the company is worth in regards to its earnings. There’s no one size fits all guide to the PE ratio, and different sectors have different averages.

Typically, it’s seen that a lower PE indicates an investment is valued cheaply, whilst a higher PE looks expensive. Whether the asset valuations are supported is another question.

Bonds

To estimate the returns on a debt security, many investors use the yield to maturity. This yield to maturity calculates the total expected return, including coupon payments and the final repayment of the principal, assuming it’s held to the end of its life.

Essentially, it’s the bonds internal rate of return.

Optimisation

Once you have outlined the expected returns for each asset class, it’s important to translate this information into allocation of assets in your portfolio to ensure your portfolio it built in the best way for you.

There are a number of complex calculations that go into this optimisation process, which needs to be robust to ensure you have exposure to the maximum possible return for a given level of risk.

Keeping the emotions out of investing

Reflection can help improve your investment habits, but it’s important you keep the emotions out of investing if you want to build the portfolio that’s going to help you reach your goals. Unfortunately, it can be rather difficult to achieve.

Here are four tips to cultivate your successful investing habits:

Let an expert manage your moneyIf you don’t have the time to properly manage your investments yourself, get an expert to do it for you. Thanks to low-cost digital wealth managers like Moneyfarm, this doesn’t need to be expensive.

Invest regularlyInstead of trying to time the market and regretting missed opportunities, set up direct debits to benefit from pound cost averaging and maximise your returns.

DiversificationDiversify your investments across asset classes and geographies, so you’re not reliant on one asset to do well.

Invest for the long term.
It’s well known that it’s ‘time in’ not ‘timing’ the market that can help maximise your returns over the long-term, helping you avoid knee-jerk reactions and allowing you to benefit from long-term growth trends.

If you want to grow your money for the future, should you try to beat the market? The age-old active versus passive debate rages on and whilst there’s nothing wrong with trying to outperform a benchmark, the expensive fees often attached to active funds can eat into your returns.

There are two main investment strategies in the investment world; active and passive. Passive investments aim to replicate the returns of a benchmark by tracking the investments within it.

As active fund managers aim to outperform their benchmark, they look to take advantage of short-term trends and try to minimise the impact of a downturn. Trying to beat the market takes a lot of resource, and these costs are then passed onto the investor, which eat into their return.

Do expensive funds perform better?

Active fund managers don’t always get it right, with these funds often underperforming the benchmark they’re trying to beat. You don’t always get what you pay for, but in active wealth management, you’re still required to pay.

Whilst fees are a fact of life when you want someone to carry out a service for you – no matter the industry – the more you pay in fees, the less of your money you get to keep and the more your investments have to grow to break-even.

Funds charge an annual management fee, which covers the cost of running the fund and is where the asset manager tries to make its profit. Expressed as a percentage, this can vary wildly from fund to fund, and can reach as much as 2%.

The ongoing fund charge is a more accurate snapshot of how much a fund might cost you over 12 months, but it still doesn’t always reveal the full picture. On top of this, you’ll probably have to pay a platform fee which enables to you buy and sell the particular fund.

Be aware of any complex fee structures or surprise charges that can reduce your return even further. You might be charges the cost of your asset manager buying and selling investments, certain admin charges or platform costs from your provider, including an inactivity fee.

It’s crucial investors understand how fees impact performance. Whilst you can never guarantee a return from your investments, you can control how much you pay in fees.

ETF investing

Exchange Traded Funds (ETFs) are passive investments that combine the low-cost nature of index trackers with the trading ease of a normal stock as they can be traded on the stock market. ETFs have surged in popularity as investors hunt out low-cost, simple and transparent alternatives to actively managed funds.

They are similar to a closed-end fund as they have a set number of units that can be bought and sold over the exchange, although these can be created or redeemed. ETFs also offer more transparency and generally don’t use leverage – unless specified.

ETFs are changing the face of asset management, as investors shift away from active funds. ETFs attracted ten times the new capital that went to traditional funds in 2017. With $460 billion flooding into ETFs globally, this breaks down to $1.8 billion on every working day of last year*.

With much of the money flowing to passive funds coming from the active management space, the stock-pickers are under pressure to lower their charges. According to Morningstar, the average net expense ratio of US equity mutual funds fell from 1.44% in 2000 to 1.13% last year. ETFs are saving investors money both directly and indirectly.

With some ETFs becoming too big for the index they track, the power passive investments now hold in the financial markets makes some big investors nervous.

Does active or passive investing perform better?

Of course it’s impossible to beat the market every year, yet active funds have been struggling. In 2016, two-thirds of large-cap active fund managers failed to beat the S&P 500, according to S&P Dow Jones Indices.

The smaller asset managers didn’t fare much better, with 90% of mid-cap and 86% of small-cap managers missing the mark.

This underperformance will have contributed to the record flows to passive funds in 2017 – the second longest bull market on record will also have helped.

Active fund managers in Europe have since pulled their socks up, and just over half of equity funds outperformed their benchmark in 2017, up from 23% in 2016, according to research firm Scope Analysis. The number of outperforming bond funds rose from 33% to 50%.

At Moneyfarm, we have nothing against active investments, but we do have a big problem with the fees investors are required for the privilege – or not, as history would suggest. Low cost investments mean investors can keep more of their money.

Of course, when it comes to passive investments, if the benchmark a fund is tracking falls in value, so will the fund – if it’s doing its job right.

Successful passive investors build portfolios that are diversified across asset classes and geographies to manage this risk. Diversification looks to offset any losses in your portfolio with gains made elsewhere.

Whether you’re deciding which fund to invest in, how to build your portfolio, or whether to invest at all, all investing carries some active decision making, whether you’re using passive instruments or not.

The right portfolio reflects your investor profile and tolerance to risk through the allocation of assets within in it. This can be difficult to get right yourself, but understanding this relationship is one of the first steps to growing your money for your future self.

You can find out what type of investor you are for free with Moneyfarm.

As an investor, you want your money to grow for you and your family’s future. But it can sometimes be difficult to have confidence in your investment decisions when you don’t have the time to master the financial markets by yourself.

Instead, a fund can help take some of the pressure off investors and provide them with a diversified portfolio that’s built and managed by a team of experts.

What is an investment fund?

A fund is an investment vehicle that allows you to pool your money together with other investors, to invest in a range of different assets. The fund will aim to grow in value or provide you with a regular income.

It’s not up to individual investors to decide the fund’s strategy, set out the asset allocation or pick the investments; this responsibility falls to the fund manager.

By investing in a fund, investors hope to get access to a diverse range of assets, greater investment expertise and lower trading fees than if they did it alone.

Diversification is a way of managing risk in your investment portfolio. By spreading your money across investments, asset classes and geographies, you hope to offset any losses with gains made elsewhere.

Funds have different strategies and objectives. Whether it’s to provide income or increase the value of your money invested. Whether you want to invest in a passive or active fund, or want to focus on a specific investment, sector, country or asset class there’s something for you.

Different types of funds

Funds have been around for many years and have evolved into many different guises. Today, different types of investment funds include exchange traded funds, mutual funds, and hedge funds.

A mutual fund is an open-end fund, which means it has no limit to how many people can invest in it. When investors add money to the fund, new shares are created; when investors withdraw their money, shares are retired. They are typically priced just once a day, which means they can be difficult to trade and lack transparency.

Closed-end funds act more like shares on the stock market, with a fixed number of units that can be traded over an exchange. These funds, like investment trusts, are mostly actively-managed and the shares can be traded in seconds, which means they offer more flexibility and transparency than mutual funds.

Active v Passive

When it comes to investing in funds, the active versus passive debate takes centre-fold.

It’s important to understand exactly what you want from your investment to make sure it matches what you’re investing in – otherwise this can really impact your returns.

Investors who want to outperform the general market will put their money in an actively managed fund. The fund manager’s team will analyse the markets for you and invest in the assets it thinks will help the fund grow in value.

This comes at a price, however, and the expensive management fees often associated with actively managed funds can eat into investor returns.

Passive investments are an alternative to these expensive funds. These funds aim to track and replicate the returns of an index, specific commodity bond, or basket of assets.

Passive investments still offer diverse expose to a range of assets, but because they aim to replicate the returns of a market, they can come with much less aggressive management fees.

What is an ETF?

With the industry feeling the heat from margin pressures, increased regulation and competition, passive investments like exchange traded funds (ETFs) have surged in popularity. Global ETF assets had reached $4.2 trillion (£3.2 trillion) by the end of August, numbers from the industry data provider ETFGI show.

ETFs are a low-cost, simple and transparent alternative to expensive actively managed funds. They are similar to a closed-end fund, but are passive investments, can create and redeem shares, offer more transparency, generally don’t use leverage – unless specified – and are lower-cost.

The right investment for you

Finding the right fund for you takes time, experience, knowledge and skill. To make sure you’re on the right track to reach your financial goals, your investments need to reflect your investor profile and attitude to risk.

It’s not easy to understand your investor profile, either – it depends on what you’re investing for, your time horizon, attitude to risk and financial history. There are funds out there designed to help you reach your goals, you just need to find them.

At Moneyfarm we match you to an investor profile and investment portfolio. This investment portfolio is specifically built and managed in line with your investor profile to help you get one step closer to your financial goals.

]]>What is investing and how do I start?https://blog.moneyfarm.com/en/investing-101/investing-money-start/
https://blog.moneyfarm.com/en/investing-101/investing-money-start/#respondMon, 27 Nov 2017 17:55:13 +0000https://blog.moneyfarm.com/en/?p=6181

A successful investment portfolio can help a saver reach their financial goals a lot quicker than saving alone.

We all have those big life goals we want to achieve, whether it’s a family holiday, getting your foot on the housing ladder, or retiring early. Once we’ve achieved those goals, we want to help those we love do the same.

Unfortunately, it’s difficult for savers with good financial habits to feel like they’re getting anywhere in this low interest rate environment, especially against the threat of inflation.

What is investing?

People invest to watch their money grow over time. Traditionally, investors put their money in an asset – whether it be a company share or bond, for example – with the hope it will generate a profit.

A successful investment portfolio can help a saver reach their financial goals a lot quicker than saving alone.

Traditionally, investors look for two things from an asset when they invest – capital growth and/or income. Capital growth is when the underlying value of the investment increases, whereas income is a periodic flow of money you get as a dividend or coupon, for example.

You have to be able to value assets to calculate the return you expect from them. Of course, nothing is guaranteed – no asset is completely risk free.

What types of investments are there?

There are a number of different investment vehicles available to those who are looking to protect and grow their money. No matter what type of investor you are, there’s an investment product for you.

You can invest in company shares on the stock market, or loan money to governments and corporations through bonds for a more stable return.

Some investors prefer more diversified investments like exchange traded funds, investment trusts and mutual funds. The money they invest in these products is then invested further by a fund manager.

The investment universe also includes property, commodities, and contracts for future purchases of an asset like oil, for example. You can also flip the dynamic and short an investment – where you make a profit by betting against the market.

Each investment vehicle has different characteristics that are suitable to different types of investors. Understanding how they work is crucial when you’re investing your money.

Building a portfolio for you

The traditional wealth management industry is a complex one and it can be difficult knowing which investments will help you achieve your goals and build a portfolio that reflects this. It all depends on your investor profile, which is determined by your attitude to risk.

One of the most misunderstood concepts of the financial markets, ‘risk’ has negative connotations. Without it, however, savers would just have to accept the impact of inflation.

By taking on more risk with your money, you increase the scope for higher returns – although your investments also have further to fall. Your attitude to risk is personal, so understanding your risk tolerance is the first step to achieving your financial goals.

Diversification

For investors, risk is about losing money – nobody wants that to happen. Diversification is a simple concept to manage risk in your portfolio.

By spreading your money across investments, asset classes and geographies, you hope to smooth out any losses in your portfolio with gains made elsewhere.

Investors looking for big returns will probably have a high proportion of equities in their investment portfolios. A diversified portfolio would still look at fixed income, however, to try and ensure stability against any unforeseen volatility.

Diversification is a difficult and expensive thing to get right yourself, which is why paying experts to do it for you is so popular. Be careful, though, some funds can come with expensive management fees and might not offer the diversification or management you’re expecting.

ETFs are a great way to achieve diversification at a low cost. A type of passive investment, ETFs track a market or investment in the hope of replicating the returns of the assets in question.

They are easier to trade than mutual funds and more transparent, essential characteristics for busy families looking for flexibility with their investments.

Investing your money

It takes a lot of time, knowledge and skill to invest successfully by yourself – and can often feel like a full-time job. You have to carefully monitor the markets, accurately analyse long-term trends, and have the skill to trade on the financial markets.

Once you’ve built your investment portfolio, the work doesn’t stop there. As markets move and your asset allocation changes, you will have to rebalance your portfolio to ensure it still reflects your investor profile.

This will ensure your portfolio is in the best position to help you achieve your long-term investment goals. Is there a way of making your money work harder for you, without breaking a sweat yourself?

Investing with a robo advisor

Discretionary products do the hard work for you, so you can focus on the important things in life. Unfortunately, the traditional wealth management industry has a number of barriers to entry that can exclude many families trying to protect their money.

Expensive fees can eat into your return and delay you reaching your financial goals. Unfortunately, these charges are often placed on funds that don’t have the performance to match.

This isn’t fair on the normal family that’s just trying to make the most of what they’ve got, which is why low-cost digital wealth managers like Moneyfarm are growing in popularity. We match you to an investment portfolio that’s built, managed and rebalanced specifically for your investor profile, so you can get one step closer to your financial goals.

The modern family needs flexibility when it comes to growing their money for the future; portfolios built with ETFs allow just that. Not only can you manage your investments at any time of day or night on your mobile or computer, but you can also see exactly what you’re invested in and how it’s performing.

The hardest question you will have to make is when you’re investing, and with how much.

However you decide to protect your money and grow it for the future, make sure it reflects the needs of you and your family.

When it comes to price, Brits often associate higher cost with better quality. It’s easy to see how investors could assume that expensive funds should generate a better return than cheaper ones, but this is a myth that could be doing more harm than good.

You can never guarantee a return from your investments, but you can control how much you pay in charges. It’s crucial you understand how much you have to pay, otherwise this could seriously hold you back from achieving your financial goals.

What are you paying for?

Funds charge an annual management fee, which covers the running of the fund and is where the asset manager usually makes its profit. This can vary wildly from fund to fund, and can reach as much as 2%. On top of this cost you’ll likely have a platform fee, or management fee from a wealth manager, this is what enables you to access a particular fund.

There are two main types of investment strategies; active and passive. Whilst passive investments try to replicate the returns on the market, active managers try to outperform it.

Trying to beat a benchmark takes up more resources than if you were trying to replicate it. Time is money, as the adage goes, and investors have to fork out for the prospect of beating the market – whether it actually happens or not.

Compensating fund managers for their time and expertise, these expensive management fees are usually disclosed as a percentage of the total amount of the money the investor has in that fund.

What’s the ongoing fund charge?

The ongoing fund charge is a more accurate reflection of how much a fund might cost you over 12 months, but still doesn’t reveal the whole picture.

By investing in a fund, you might be charged the cost of your asset manager buying and selling investments, certain admin charges, or platform costs from your provider. These costs add up quickly and it can be difficult to understand exactly how much you’re really paying.

Do expensive funds perform better?

So, asset managers charge big bucks on the promise that they could deliver outperformance; but do the more expensive funds actually perform any better?

Two-thirds of large-cap active fund managers failed to beat the S&P 500 index in 2016, research from S&P Dow Jones Indices shows. The smaller asset managers didn’t fare any better, with 90% of mid-cap and 86% of small-cap fund managers missing the mark.

It’s a tough task asking active funds to outperform passive funds after fees for a simple reason; they have to get a higher return to compensate for their higher fees.

Granted, you can’t expect a fund manager to outperform every year, especially when markets are performing well, but a look at longer time horizons showed the majority of active fund managers also failed to outperform over one, three, five, 10 and 15 years.

The UK regulator, the Financial Conduct Authority, found a negative relationship between the cost of a mutual fund and the performance of the fund manager in its final report on the asset management industry.

The research even found that more expensive funds underperformed cheaper active funds, although this varied across sector.

The prospect of outperforming the market is not a concept many will be staunchly against, but the high fees that go hand-in-hand with active management do eat into investor returns and delay the achievement of financial goals.

Although everyone has the right to protect their money and grow their wealth for the future, many are put off by the high barriers to entry. Instead, investment products should be low-cost, transparent and effective to encourage savers to start preparing for their future, whatever it holds.

Fed up with underperformance, expensive fees and a lack of transparency, investors are turning to passive investments as an alternative to the status quo.

It’s not a new debate, but the questions around cost, performance and transparency just aren’t going away – and rightly so. In fact, it’s expected that 2017 will see the most money flood into passive investing¹.

Active management vs passive funds

Traditionally, an active fund manager looks to outperform the market and commands higher management fees for the trouble.

On the other hand, a passive fund manager looks to replicate the performance of the market or investment – often through products like exchange traded funds. Passive funds traditionally have lower management fees attached to them.

The problem is, a lot of active funds don’t consistently outperform particularly after fees, which makes their high fees, well, a bit hard to justify.

Research from S&P Dow Jones Indices shows that a whopping two thirds of large-cap active fund managers failed to beat the S&P 500 index in 2016. At look at the smaller managers was even more worrying, with nearly 90% of mid-cap and 86% of small-cap fund managers missing the mark, respectively.

Granted, it’s probably unrealistic to expect a fund manager to outperform every year, but a look at longer time periods still showed that the majority of fund managers failed to outperform over one, three, five, 10 and 15 years.

Not only might investors be failing to offset the impact of inflation or grow their money to achieve their goals, but they’re still having to pay for it. Now, if I went for out for dinner with my family and was given poor service, I would question the bill and most definitely refuse the service charge.

How are active fund managers reacting?

Active fund managers are now feeling the heat and Fidelity has become the latest to show its hand in the active/passive duel, in a bid to rebuild trust.

Following in Allianz and AllianceBernstein footsteps, Fidelity has overhauled its pricing structure by introducing so-called “fulcrum fees” on some of its mutual funds. Moving away from its flat fee model, investors will pay more if the fund outperforms. If it falls short, they’ll pay less – simple as that.

Fidelity hasn’t specified what the minimum and maximum limits will be yet, but the model will be calculated on a rolling three-year period and fees won’t be charged for the initial year after adoption.

It’s a bold move that could, if industry trends continue, create volatility in the earnings from asset managers – although it could bring a bit of excitement back into the active management space. Smaller asset managers could also struggle, especially against bigger firms that could benefit from a diverse range of products, inlcuding passive.

As investors will only pay active management fees when their fund manager delivers, this fee structure should will drive greater transparency in the industry. It should also encourage fund managers to take on more risk and reduce the number of so-called “closet-indexers” – manages who charge an active fee for what is basically passive exposure.

Investors shouldn’t be paying inflated prices for something they could get cheaper elsewhere. It’s just not fair and creates an environment of suspicion that the industry needs to work hard to eradicate.

Helping investors achieve their goals

Let’s get this clear; I’m not against active fund management as a concept. If investors can get returns that outperform the market, they can achieve their financial goals quicker – what could be better than that?

But fund managers interests could be better aligned with those of their investors. If you outperform, you’ve delivered your service and earned your fee.

The current savings environment is a challenging one. We’re living longer but saving less. The value of the money we do build up in cash savings accounts is being eroded by inflation. We need to encourage Brits to make their money work harder to achieve their life goals. The first step is to provide a clear, transparent and fair platform to do so.

1 2017 Will See The Most Money Shift To Passive Investing, Due Largely To Fees

Would it be better to rebalance the Moneyfarm portfolios more often to ensure they keep up with equity markets all the time?

Chief Investment Officer, Richard Flax:

This is a really interesting question because it’s always tempting to trade more. On the asset allocation team we spend all day thinking about the markets and inevitably find some attractive short-term ideas along the way.

But we know short-term trading carries more risk and more cost. And it often doesn’t deliver the results you’re looking for. There are a lot of people looking for that elusive “edge” in financial markets, but often the greatest edge you can have is simply your time horizon. Having that long-term time horizon is one of the greatest tools for wealth creation.

Our investment decisions are based on long-term investing – starting with our strategic asset allocation. This approach involves setting target portfolio allocations for each asset class based on an investor’s risk profile.

A mistake investors can make is to drift away from their original strategy – taking on more risk when you originally wanted less volatility, for example. Each of our portfolios are built on a strategy that works for the goals of the corresponding investment portfolio.

Of course, markets move and opportunities present themselves all the time. It’s up to us to fully research each opportunity and make shorter-term adjustments when necessary – this is called tactical asset allocation.

Market movements also move the proportion of assets in our portfolio away from the target asset allocation. It’s up to us to rebalance our portfolios to ensure they match the risk appetite of our investors.

Long-term investing

At Moneyfarm, we’ve built an investment philosophy based on a long-term investing. Each year we look at expected returns for a 10-year period and then develop appropriate asset allocation based on this. We always look to ensure our portfolios are robust as possible, but we do this within the framework of the portfolio objectives, we’ll make slight adjustments, not complete changes.

Even if you’re confident enough to put all your money on one investment, it’s a dangerous game to play. If it goes up in value you’re laughing, but it could also be painful if it vanishes before your eyes.

This risk can be reduced through diversification, and is why we like to invest in exchange traded funds (ETFs) and ensure our portfolios span asset classes and regions, appropriate to an investor’s tolerance to risk. As the main asset classes rarely perform in line with each other, losses from one investment can be offset from gains made elsewhere.

At the moment, our portfolios are feeling the impact of a stronger pound and geopolitical tensions between the US and North Korea, as well as the disaster caused by Hurricane Irma.

When you look at the performance of your Moneyfarm portfolios, remember these three things:

These are globally diversified portfolios that include bonds and equities.

We measure the portfolio’s risk-adjusted return – what return do we get for the volatility in our portfolios?

We adopt a long-term investment horizon rather than focusing on results from just one quarter.

Markets rise and fall, but our team manage the risks accordingly. Although it can be tempting to react to short-term fluctuations, sticking to your investment strategy should avoid any costly mistakes from trying to time the market.

If you have any questions that you’d like Richard to answer send them to support@moneyfarm.com with the subject line ‘Question for the CIO’, and we’ll either respond to you directly or publish them on our blog.

The FCA’s 112-page report on the UK’s £7 trillion asset management industry landed on my desk this week, calling for greater transparency and better price competition to rebuild trust and help people protect and grow their wealth for the future.

Met with mixed reviews, the report didn’t raise anything we didn’t already know. There’s limited pricing competition in the industry and a lack of transparency, which leads to overcharging. Whilst investors try to get their head around these pricing structures, some traditional asset managers are raking in big profits.

Pricing is an important issue. Proactive families that are trying to grow their hard-earned money are struggling to know exactly how much they’re being charged and what they’re being charged for. How can you work out your potential future wealth if you don’t know what you have to pay for?

What’s even more worrying is that there is evidence that investors are more likely to pick a fund with higher charges over a cheaper one in the same market, believing they’ll get better returns. The FCA, however, found no link between the two. I’m happy to pay, but I expect high quality to come with that extra cost, much like a good pair of running shoes.

Closet-tracker funds

The FCA also found that there’s £109 billion sat in what it calls closet tracker funds, which means investors are unknowingly paying higher active management fees for what is effectively a passive management service.

Funds can be split into two groups depending on their management style. Active fund managers have a more hands on approach to portfolio building in the hope of beating the market, although this means they demand higher charges. Passive fund managers track major indices to achieve the same returns as the market.

There’s nothing wrong with tracker funds; in fact, I often prefer investing in low-cost exchange traded funds to stock-picking. I just don’t have the disposable income, time, or expertise to achieve successful diversification by myself. ETFs allow me to have diverse exposure to an entire market, without the costly price tag.

Some passive funds also came under fire for underperforming their benchmark and charging people more than the average.

What has the FCA proposed?

Although important, the FCA’s findings weren’t a surprise, and the so-called remedies proposed by the FCA lack some gusto. I’m sure investment managers let out a small sigh of relief.

But the proposals are a step in the right direction; the FCA wants to standardise the reporting of costs and charges and increase the transparency of cost by adopting an all-in fee – including the asset management charge, estimated transaction costs and distribution fees. This will be consulted on later in the year.

Under Mifid II, regulation for European investment services, asset managers will have to include an all-in fee at every stage of the transaction, shown in percentage and numerical terms.

This will make it easier for investors to understand what returns they’re getting. If people are working hard to protect their money for their future, it’s only right that the asset management industry doesn’t take advantage.

The UK will have been stuck in a low interest rate environment for 100 months in July. The financial sector gives Brits the scope to make a return on their savings, especially as inflation accelerates.

Overhauling the charging and pricing structure and stoking competition is crucial to ensure people get value for money, maximise their returns, and improve their future financial wellness. I’ll raise a glass to that this weekend. 1 Ripping of customers is nothing new for asset managers, Financial Times, June 2017

When you’re investing your money, it can be tempting to monitor its performance with military-style surveillance. And now you can manage your wealth on your phone, it’s easy to listen to, analyse, and react to the market within seconds.

Investing is personal and, as you’re saving for your future, it carries a lot of emotion. But this regular monitoring of your portfolio can be stressful and force you to make knee-jerk reactions to temporary market movements, which can leave you worse off in the long-run.

Life is a roller coaster

The financial markets are often compared to a roller coaster, with increases in value swiftly followed by declines – a view that can be reinforced by media rhetoric.

It’s normal to be nervous when you come to invest your hard-earned money. But this volatility that evokes fear in so many, is a necessary component of financial investments – it’s what drives the value of our holdings up, as well as down.

As financial markets don’t exist in a vacuum, this volatility is influenced by the performance of the investment itself, as well as economic and political events. This exposure to risk can put nerves to the test if investors aren’t matched to the right invest strategy.

Long-term benefits

It’s possible to adopt highly speculative investment strategies in the hope of taking advantage of short-term investment trends. Savers looking to protect and grow their wealth for the future, however, are advised to look to the longer-term horizon instead.

Take a look at the two tables below. The first graph shows the performance of an index; you’ll notice it’s hard to outline a clear trend as the performance is erratic. Sudden increases in value are soon followed by steep declines.

Now look at the second graph. You’ll notice that this graph looks quite different, with a definite growth trend represented on the graph. There are still moments of volatility, but these are part of a medium-term trend that carries momentum upwards.

What’s the difference between the two investments? There isn’t one. It’s the same S&P500 index reflected in the chart, what’s different is the time frame. Where the first index reflects a six-month view, the second shows five years.

By changing the perspective of time, an investment that looks highly volatile and with no clear trend turns into a more stable investment with a clear upward trend.

Invest with confidence

Clearly, time is crucial when you’re investing. Adopting a long-term horizon helps you build a well-balanced portfolio that can manage the volatility within it by offsetting losses with gains made elsewhere. This also allows any investor to benefit from long-term growth trends.

More importantly, if you’ve got a well-diversified portfolio with a long-term horizon, you shouldn’t be anxiously checking your investments on the beach when you’re on holiday, or getting up in the middle of the night to monitor global markets.

You’ll still want to know how your investments are performing, of course, but you’re less likely to regret any knee-jerk reactions with a long-term strategy. Instead, any portfolio adjustments will be based on thought-out assessments and careful analysis.

We encourage you to invest for your goals and in a way that suits your risk profile. It’s important that you can grow your money for your future, without it taking its toll on your emotions. But you should also have the power to check your investments as often or as little as you like.

The passive investment world can be rather confusing to the inexperienced investor. You have passive tracker funds and exchange-traded funds (ETFs), both track a benchmark, and both are expected to give you performance which mirrors that of the benchmark it tracks. They work because they allow you to build low-cost, diversified portfolios. But what’s the difference?

Structure

Most index funds are set up as either open-ended investment companies (OEICs) or Unit Trusts (the UK equivalent of a mutual fund). These are known as open-ended because the supply of shares is not restricted, new shares can be created to meet the demand from buyers, or shares can be reduced to meet the obligations of the sellers. ETFs on the other hand trade on the stock exchange like any other share.

Pricing

The price of both tracker funds and ETFs mirror that of the benchmark it tracks. That means if the value of the assets that make up that benchmark drop, so will the price of the tracker or ETF. However, you don’t usually know the price of the index fund before you buy it, this sounds strange and is known as forward pricing, you will pay the price at the funds next valuation, this happens at a set time each working day. The price of an ETF is subject to change throughout the day, like a normal stock, and you will know the price of the ETF before you buy or sell.

Variety

Choice in the index fund world can seem rather limited, in terms of both asset class and providers. There are entire asset classes which don’t have any index funds, and even when the index funds exist, there’s only a handful of suppliers. ETFs on the other hand almost have too much choice, there are ETFs for large, diverse markets, and even for specific industries. It’s important to understand what you invest in, or to take advice from professionals.

You pay your active investment manager a reassuringly high fee to manage your money, they scan the market, have a benchmark to beat and you’re expecting some strong returns. But successful active managers rely on judgement, experience and investment technique; how many actually manage to generate above-average returns on a consistent basis?

In contrast passive investments aim to replicate the performance of an index. The lower charges offer an appealing alternative; after all cost is the only guarantee in investments.

1. Low-cost passive investments

The main advantage of a passive investment is the cost. According to the investment association the annual charges on active funds are 1.59% when transaction costs are factored in. Conversely a passive investment, such as an exchange-traded fund (ETF) could cost you as little as 0.1%.

Cost should always be looked at in relation to returns, there is little point in paying 1.59% for 2% returns if you can pay less and achieve a similar level of returns. In the current investment environment many active managers are taking on more risk to have the potential of higher returns, but with risk also comes the higher chance of potential losses.

For investors looking to limit the impact annual charges have on returns a passive investment is the logical strategy. In today’s income-starved market investors need to be more cautious of cost than ever before, it is really difficult to justify fees approaching 2%.

2. Passive investments are more simple

When you buy a passive investment you know exactly what you are getting. You know which index it is tracking and you can see the performance on a regular basis. With Moneyfarm our performance is updated daily, if you wanted you could see how each ETF in your portfolio is performing on a daily basis.

Many active managers update investors on a much less regular basis. This varies by manager but it could be once a month, once a quarter or even once a year. This could leave you scratching your head as you fork out management fees but can’t really see what’s happening with your money.

3. There are good and bad active managers

There are some really fantastic active managers out there but for every good one there is a terrible one. The difference in performance between them could be huge over the long term. With a passive investment you know what you are getting, you should receive a similar performance to that index.

There are good and bad funds in both the active and passive investment universe. If you’re in any doubt of whether it’s a ‘good’ investment seek advice. Moneyfarm provide advice to all users, we let you know your investor profile and the portfolio that would best suit your needs before you’ve paid us a penny.

Monday 13 June May inflation data for the UK with the CPI (expected +0.3% mom; +0.1% previous), RPI (expected +0.3% mom; 0.1% previous) and PPI (expected +0.3% mom; +0.4% previous) numbers due – all of which should be watched closely ahead of the BoE meeting on Thursday. Tuesday 14 June In the UK, the May […]

May inflation data for the UK with the CPI (expected +0.3% mom; +0.1% previous), RPI (expected +0.3% mom; 0.1% previous) and PPI (expected +0.3% mom; +0.4% previous) numbers due – all of which should be watched closely ahead of the BoE meeting on Thursday.

Tuesday 14 June

In the UK, the May inflation numbers largely came in softer than expected. CPI (+0.2% mom vs. +0.3% expected) and PPI (+0.1% mom vs. +0.3% expected) both came in lower than expected, and while RPI was in line with expectations on a monthly basis (+0.3% mom). We also saw the final May CPI numbers for Italy (-0.3% YoY) and Spain (+0.5% mom; -1.1% YoY), both of which were in line with expectations. Eurozone April industrial production data out of the, which clocked in at the very upper end of the forecast range and well above expectations (+1.1% mom vs. +0.8% expected).

In the US, the NFIB Small Business Optimism index for May exceeded expectation and hit its highest level since January (93.8 vs. 93.6). US retail sales also beat expectations and posted an increase of +0.5% mom in May (vs. +0.3% expected).

Wednesday 15 June

FOMC meeting concluded that the base interest rates will be kept unchanged at 0.50%.

In Europe, French May CPI provided a surprise on the upside at +0.5% mom (vs. +0.3%expected). Prices were up +0.1% YoY (0.0% expected). In the UK the labour market remains resilient despite uncertainty ahead of the upcoming referendum, with the unemployment rate for May declining to 5.0% (vs. 5.1% expected; 5.1% previous) – the lowest levels since 2005. Wages growth also ticked up as weekly earnings increased by +2.3% 3m/YoY (vs. +2.0% expected; +2.2% previous).

In US, we saw producer prices for May tick up by +0.4% mom (+0.2% previous) and beat estimates (+0.3% expected), primarily driven by the biggest rebound in energy costs since May 2015.

Bank of Japan, Bank of England and Swiss National Banks kept their base interest rate unchanged at -0.10%, 0.50% and -0.75% respectively.

The yen has touched its strongest level in two years after the Bank of Japan stopped short of easing policy, while demand for developed world government debt is keeping yields at notable lows after inaction from the Federal Reserve and the Bank of England.

UK retail sales grow faster than expectet for May at 0.9% to 0.2%, which lead to a YoY growht of 6% compare to 3.9%.

US jobless claims rise to 277,000 this week from 264,000 the week prior.

Friday 17 June

Japan’s PPI for May came in line with expectation at 0.2%, and brought YoY PPI to be -4.2%.

US building permits in May was slightly below market expectation at 1.13 million, compares to 1.15 million forecast. Canada CPI in May showed a MoM gain of 0.3%, in line with market expectation.

]]>https://blog.moneyfarm.com/en/market-review/financial-markets-review-17th-june-2016/feed/0How to achieve the best long-term investmenthttps://blog.moneyfarm.com/en/investing-101/achieve-best-long-term-investment/
https://blog.moneyfarm.com/en/investing-101/achieve-best-long-term-investment/#respondThu, 12 May 2016 15:19:22 +0000https://blog.moneyfarm.com/en/?p=3800

It is widely believed that higher risk is equal to greater returns. Therefore, by taking on more risk in the portfolio (by buying more equity for instance) one would expect higher returns in the long run than investing in lower risk asset classes, such as bonds. However, this theory implies that higher investment risk will […]

It is widely believed that higher risk is equal to greater returns. Therefore, by taking on more risk in the portfolio (by buying more equity for instance) one would expect higher returns in the long run than investing in lower risk asset classes, such as bonds.

However, this theory implies that higher investment risk will only lead to the possibility of higher returns and will not guarantee higher returns. Investors need to be aware that in the same way that risk can lead to higher returns, it can also lead to higher losses.

Equity is often considered to be the more ‘risky’ asset class, but does it make the best investment in the long term? Looking at equity risk premium, the excess return that investing in the stock market provides over risk-free return such as yield on holding short-term government bonds, equities are in general riskier and more volatile than government bonds. Therefore, equity should offer the prospect of greater returns compared to bond investments and compensate for the excess risk that equity investors are taking on.

Between 1928 and 2015 there were some of the most famous financial market booms and busts of the last century. The below table compares key asset classes in the US market over this period. They are evaluated for the entire period as well as two sub periods; this shows the impact of different economic cycles on the US market. Over the long term the US equity market (S&P 500) generated a higher return than both bond investments (Treasury Bond) and cash (Treasury Bill).

Annualised Return

S&P 500

3-month T.Bill

10-year T.Bond

1928-2015

9.50%

3.45%

4.96%

1966-2015

9.61%

4.92%

6.71%

2006-2015

7.25%

1.14%

4.71%

It is all relative

Investors need to be aware of single country influence. Many studies on equity market returns are based on data from the start of the 20th century. Global equity market performance was largely driven by the US in this period. Over the past century, the US market is somewhat of an outlier in global equity markets.

If investors, at the start of the 20th century, had picked the German market as the destination for their long-term investments, a reasonable choice at the time, they would have seen their assets erased by hyperinflation in the 1920s and by the the two World Wars. If investors had chosen the UK in 1900 as their long-term investment target, their return profile would be very different to that of an investor who had chosen the US markets.

According to a study on long-term investment returns published by academics at the London Business School* many developed equity markets, including the US, suffered a long period of negative real returns (nominal return – inflation rate) over the last century. It would have been a struggle for most retail investors to wait for that recovery, both financially and psychologically.

The chart below compares the total returns (including dividend and coupons) from equities (MSCI World), bond investment (mixed of corporate bond and government bond at different maturity) and commodities over the past 20 years, this showed that bonds actually outperformed equities in the long-term, despite the equities recovery after 2009. By cherry picking a different starting point of evaluation, the chart could show a very different result, however the period we are evaluating does cover a fairly comprehensive business cycle such as the dotcom boom and bust, and the Financial Crisis of 2008 and the subsequent recovery.

Do not put all your eggs in one basket

It is reasonable to conclude that equities are not necessarily the best asset class in the long term and investors should accept that equities can underperform compared to other asset classes. It is particularly relevant for investors who are willing to take on greater risk and have higher equity allocation in their portfolios, as they can be very exposed to large losses when things start to go wrong.

A rationale investor should therefore consider factors such as starting valuation (when starting valuations are high, future returns will be lower and the likelihood of outperforming decreases) when making an investment, or diversifying their investment into different asset classes and to have alternative drivers of performance in the portfolio. In the long run, a strategically designed, well diversified portfolio, is much more likely to prevail than investment into any single asset classes.

The asset management industry is vast. With active and passive managers, individuals are constantly on the hunt for the best returns. Many would assume that the best returns come from the active managers as teams aim to beat the market. But some are now saying that the active industry has grown too large to consistently […]

The asset management industry is vast. With active and passive managers, individuals are constantly on the hunt for the best returns. Many would assume that the best returns come from the active managers as teams aim to beat the market. But some are now saying that the active industry has grown too large to consistently produce market-beating returns.

Active portfolio managers are struggling to consistently beat their benchmarks after fees are taken into consideration. Many investors are now turning their backs on traditional stockpicking funds in favour of passive options, such as exchange-traded funds (ETFs).

This move is changing the shape of the market. Last year ETFs attracted $2,871 billion in assets, by comparison, actively managed funds lost $124 billion.1 ETFs are even starting to overtake more ‘secure’ investment methods such as bond funds.

When mutual funds grow to a certain size the incentive shifts from attempting to ourperform the benchmark to not wanting to underperform. This makes the fees associated with these funds difficult to justify as an ETF will generally match its benchmark minus the tracking error (the cost).

As the size of the actively managed funds have grown so have the number of employees. But since timing the market is a difficult skill, not dissimilar to gambling, the number of talented individuals able to do this has not increased. Many mutual funds charge much higher fees for performances similar to those achieved by ETFs.

The active industry needs to ensure that the availability of skill matches the size of the market they are able to cater to. Otherwise they are in the territory of over promising their customers.

Individuals need to be prudent when choosing their investment channel and ensure they take cost and anticipated performance in to consideration in tandem. The only thing you can completely control when investing is cost. If you are going to be paying more you need to ensure you are getting more for your money, otherwise wealth accumulation becomes that much more difficult.

The investment management industry is evolving and there is now a wide variety of investment options available to retail investors. Whether you are looking for an equity, bond or commodity product the main distribution channels now offer access to all of these. Once you have chosen your asset class, the next decision is whether you […]

The investment management industry is evolving and there is now a wide variety of investment options available to retail investors. Whether you are looking for an equity, bond or commodity product the main distribution channels now offer access to all of these. Once you have chosen your asset class, the next decision is whether you want to buy an active or passive product. Buying an active product means that you are making a bet that the team you allocate money with will beat a predefined benchmark (eg Eurostoxx 600 or FTSE 100).

Historically, buying active products was the only way to invest in financial markets, but over the past few years the prevalence of passive investments has been growing. Buying a passive product (e.g. an exchange traded fund) is based on the belief that active products cannot beat the predefined benchmark. The goal of a passive investor is to mimic benchmark performance whilst minimising the product cost.

According to ETFGI, a research and consultancy firm, exchange traded products listed in European exchanges reached the $500 billion threshold in 2015. Only 10 years ago this number was only around $58 billion. There has been growth of more than 800%. The passive investment growth explosion is partially to blame for the drop in active products assets under management, many analysts argue this is structural, not cyclical.

The number of skilled managers with robust performance had been falling over time. Investing is a negative sum game: it is possible that active investors add value, but if they do, it is at the expense of other active investors. If cost is taken into consideration the end-performance of that active investment is dragged down.

Academic research suggests that there is no clear evidence that mutual funds do better than the market when an investors long-term goal is taken into consideration. According to Ferreira equity mutual funds across the markets underperform the market overall, and in the US the fund size is negatively related to fund performance and there is some sort of short-run persistence in fund performance.1 In the bond space there is no evidence of positive performance after costs according to Chen.2 UK equity mutual funds are the exception, but only a relatively small number of top performing funds exhibit stock picking ability according to Cuthbertson.3

The first quarter of 2016 was the one of the worst according to Bank of America Merrill Lynch. They looked at US equity funds against the benchmarks. Only 19% beat their benchmark despite the greater return opportunities that come with higher dispersion, this performance is lower than what would be expected and some might argue that the difference is not only related to costs, but could also be due to a potential lack of skills too, this puts the business model of mutual funds at risk.

The current environment does not look great for active management and potential disappointment from the performance of the next quarters could accelerate the proliferation of passive products. What is still key in this environment is the right mix of assets (equites, bonds, commodities, and currencies). At Moneyfarm we blend these assets to provide an optimal risk adjusted return stream for investors based on the idea that the most important decision for investors is asset allocation. We believe stock or bond picking is hard to do in the long term, so passive exposure to asset classes with an appropriate rotation through market cycles and keeping costs low is part of the recipe to provide a solid long-term performance.

Many portfolios are managed to a benchmark, typically an index. Investors buy index exchange traded funds (ETFs) and passive mutual funds to achieve the performance of a market index without incurring the fees associated with active stock picking. Not all funds track their indexes as closely as others. The difference between a fund’s performance and […]

Many portfolios are managed to a benchmark, typically an index. Investors buy index exchange traded funds (ETFs) and passive mutual funds to achieve the performance of a market index without incurring the fees associated with active stock picking.

Not all funds track their indexes as closely as others. The difference between a fund’s performance and the performance of the index it tracks is known as tracking error. Tracking error should influence your decision when it comes to the selection of a fund.

What is tracking error?

Tracking error is a measure of the difference between returns from a fund and it’s corresponding benchmark. The lower this number is the better, if the tracking error is high the fund manager has not taken the right level of risk, this is regardless of over or under performance.

Tracking error are mostly associated with passive investment vehicles. Typically, active funds are trying to achieve the best performance possible and beat inflation, whilst passive funds are trying to match the performance of a market.

Tracking error within an ETF

With an ETF you pay the management fee and the costs of trading and this is known as the total expense ratio (TER). Typically tracking error will be equal to the TER. An investor expects the ETF to perform in the same way as the index it tracks, this is because the ETF buys a slice of that market at the same weight as the index. If the index returns 10% and the TER is 50bps the ETF investor will receive returns of 9.5%.

The TER of ETFs is typically lower than other types of funds; this is one of the reasons MoneyFarm uses ETFs in portfolios. By ensuring costs or the TER is lower you ensure that the index is tracked more accurately.

In some situations, a fund does not hold all of the securities that make up the index, this can cause tracking error to be higher. For example, a global bond index could be made of 2,000 bonds, not all of these are traded and an ETF might hold 200 or so of these, it is not an exact replication. The ETF would replicate the same exposure but not the exact composition of the index. There are a number of reasons why an ETF may not hold all securities:

Cost

Difficulties in creating and redeeming the shares

Liquidity – some stocks are not liquid enough to be bought by a fund without impacting the stock price.

Why not invest in the original stock?

To remove tracking error completely an individual could try to replicate the index themselves by investing in the original stock. However, to replicate an index such as the FTSE100 in the same way as the ETF an individual would need around £100,000. With an ETF you could have a slice of the FTSE100 for £150. Not only this, but if you buy the stocks themselves you are then subject to stamp duty and this could impact your real returns.

Imagine you bought a Ferrari, but you discovered that under the bonnet there was a Fiat engine. In the asset management industry, this is called Index Hugging. This February the European Security and Markets Authority (ESMA), the Authority that contributes to safeguarding the stability of the European Union’s financial system, provided the preliminary details of […]

Imagine you bought a Ferrari, but you discovered that under the bonnet there was a Fiat engine. In the asset management industry, this is called Index Hugging.

This February the European Security and Markets Authority (ESMA), the Authority that contributes to safeguarding the stability of the European Union’s financial system, provided the preliminary details of its latest study focused on verifying and quantifying the practise of Closet Indexing in the European asset management industry.
Closet Indexing (also known as index hugging) refers to the practice of fund managers claiming to run an active portfolio while in reality they are just replicating a benchmark, whilst charging management fees in line with actively managed funds. This strategy requires less effort form the portfolio manager so in theory fees should be lower. In reality it results in a practice that leaves investors worse-off than if they had bought a cheaper index in the first place.

The case

The investigation carried out by ESMA was prompted after several shareholder’s rights groups complained that funds were charging high fees for active management, whilst mimicking an index. The first complaints came from Better Finance, the Brussels based investor protection group, which in 2014 called on ESMA to investigate. Since then, some regional regulators started to put effort into finding and pursuing index huggers.

The Norwegian market authority was the first in Europe to make a public accusation. In March 2015 they accused the largest Norwegian bank (DNB) of mis-selling a “closet tracking” fund. During a wider investigation into whether Norwegian equity funds are actively priced and marketed, the regulator examined the indicted fund over a five-year period and found that the fund performed very closely to the benchmark, but was marketed and priced as an actively managed fund.

In December 2014, the Swedish Shareholders’ Association accused Swedbank Robur, the asset management arm of Sweden’s largest bank, of mis-selling funds that charge high fees for active management but do little more than mimic an index. The claim was filed with Sweden’s National Board for Consumer Disputes, and there was a strong denial from the Bank. Later on, the claims were extended to two more of the biggest banks in Sweden, Nordea (also admonished by Norwegian regulator) and Handelsbanken. The case was dismissed in July by Sweden’s National Board for Consumer Disputes, there were suspicions of lobbying activity by the bank. Nevertheless, it helped to put a spotlight on this practise which is spreading across Europe. Following these cases, the Danish authority also started to investigate the matter.

Recent development

Recently, some academics started to show interest in closet indexing practises. Last year a pool of professors from universities across the globe wrote “Indexing and Active Fund Management: International Evidence”, in which they tried to quantify the amount of total net assets in developed markets that are actually passively managed but actively charged. They define an index manager as a closet indexer if the fund holds an active share (share of portfolio holdings that differs from the benchmark index holdings) lower than 60%. Chart 1 illustrates the results of their study.

In this study, academics found that in some countries, especially in Europe, more than half of domestic equity funds could be closet indexers. Whilst the US, the world’s largest asset management market, had the lowest proportion of closet trackers. It is easy to see a strong relationship between the percentage of index huggers and markets dominated by large banks with strong distribution capacity.

Results of ESMA investigation

ESMA selected a sample of funds publicly sold in Europe, with assets under management bigger than €50 million, management fees higher than 0.65% and an inception date before 2005. The resulting sample contained more than 2,600 funds, of which, only 1,251 had enough data to be analysed. It used active share tracking error (volatility difference in returns between the fund and its benchmark) and other statistical metrics to define index huggers. The preliminary results show that between 5% and 15% of actively managed equity funds in Europe could be closet trackers, underlying the necessity of additional supervisory work.

What is next

At the moment, despite a lot of pressure from different associations, ESMA refuses to publish the names of the suspected index huggers. It is now up to the national regulators to set a framework for further investigation, and we can be sure that it is only the beginning of a process that will help to make the asset management industry cheaper and more transparent.